During a 2010 holiday in Singapore I started thinking about how best to summarise the lessons I have learnt from the financial crisis in 2008 and 2009.
It was very sure as to what my biggest lesson was. It was the realisation that it’s far more difficult to buy during a market panic than what I thought it would be.
I can still vividly remember me looking at companies in the first quarter of 2009 and wondering if I should buy if the company was trading at a price earnings ratio of 3.4, no debt and a reasonably recession resistant business model.
I just didn’t have the courage.
What I also did was extrapolate the most recent past into the future, a classic behavioural mistake.
Once the market started falling I did not believe it would stop and that the crisis would continue. This thinking even prevented me from buying when the market turned around as I kept on thinking that the next leg down was imminent.
Just as I was putting my thoughts together to write my list of lessons James Montier (at GMO in London) published his list of lessons not learnt during the crisis in an article called Was it all just a bad dream? Or, then lessons not learnt (free registration required)
I have been following James’s writing since 2007 and can honestly say he really knows what he is talking about.
So rather than me trying to reinvent the wheel here’s a short summary of the 10 lessons.
Lesson one – Markets are not efficient
James has convincingly argued in a lot of previous writing that the efficient market hypothesis is dead. If markets are efficient how can bubbles develop and then burst?
Markets may be efficient some of the time but at times completely irrational.
Lesson two – Relative performance is a dangerous game
As I’ve said in the past the only thing that matters is the year on year real growth in your net worth irrespective of what the markets does.
James is of the same opinion and quoted Sir John Templeton which said that the true aim of investment is the “maximum total real return after tax”.
I could not say it any better.
Lesson three – The time is never different
As soon as you hear the phrase “this time it’s different” you better make sure that you start running in the opposite direction.
The phrase was used a lot during the Internet bubble when analyst were saying that profits didn’t matter any more but clicks and eyeballs did.
Well, we al know how that ended.
Before the current crisis statements like house prices can keep on increasing irrespective of the multiple to income, and that home refinancing can continue to be used as ATMs without any consequences.
It was not any different and it will never be.
Lesson four – Valuation matters
Successful investing is really a very simple process.
You look for undervalued investments, you analyse them, and should you be convinced of the merits you invest. Should you not find anything undervalued you hold cash.
Or, more importantly, avoid buying expensive assets.
Lesson five – Wait for the fat pitch
This goes along with the previous lesson.
We should wait until you find something really undervalued and then invest.
As I mentioned above is exactly where I failed. I was about 80% in cash and when stocks really became cheap in March 2009 but I was too terrified to buy.
Lesson six – Sentiment matters
James argues that investor returns are not only affected by valuation but that sentiment also plays a part.
What it comes down to is that markets are really driven by fear and greed.
James mentions a study by a Baker and Wurgler which found that when sentiment is low the best profits can be made by buying young volatile and unprofitable companies and when sentiment is high it is best to buy mature, low volatility profitable companies.
This may sound counter-intuitive but isn’t really. It just shows you that you should invest against the crowd.
Lesson seven – Leverage can’t make a bad investment good, but it can make a good investment bad
The problem with leveraging an investment is that you are no longer your own master, as it reduces your ability to hold your investments in times of extreme price falls.
Irrespective of how irrational a price fall may be, margin calls and security deposits can force you to sell an investment at its lowest price.
And, to add insult to injury, leave you with little or no capital to make any further investments to recoup your losses.
As soon as you use leverage you lose flexibility.
This is what happened in crisis when people became forced sellers because of leverage. This started an avalanche with more investors having to sell because of prices continuing to fall.
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Lesson eight – Over-quantification hides real risk
The more complex a product is the higher the fees Wall Street can charge for it but complexity doesn’t necessarily make a product better.
With higher fees from complex products you can be sure where Wall Street’s preference lies.
Lesson nine – Macro matters
The macro economic environment does matter.
Ignoring macro indicators for example led investors into financial stocks as the bubble burst, because they were unbelievably cheap on historical valuation metrics.
Just in time to lose a substantial part of their capital.
Lesson ten – Look for sources of cheap insurance
If insurance is cheap it is most likely the contrary position and it is worthwhile buying.
In spite of my lack of courage to buy when stocks were really cheap, 2009 was not a bad year for me.
On a portfolio 71% in cash I managed to generate a return of 6.5%.
It’s not close to the European STOXX 600 index return of 28%. But in my return the journey was not nearly as hair-raising as the rollercoaster ride the index took investors on.