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This was written in January 2010 and was published as a chapter in the IoD Handbook of Personal Wealth Management 2010.

How to be a smarter investor – what to learn from 2008-09

Hindsight is a wonderful thing – clearly it can be used unfairly to castigate people for poor decisions based on subsequent events, but it can also be used very effectively for learning from the past in an attempt not to repeat mistakes, although that very learning may easily lead to other mistakes in the future. However the near total collapse of the world’s financial system in October 2008 and the volatility experienced across all types of financial market in the process offers many lessons that have a recurring value and are not just specific to the events of 2008-2009.

The history of financial markets shows that these sort of financial collapses do recur and these collapses have similarities; although the precise events are never the same, there is a sense in which they rhyme. It is also true that such collapses occur only every 50 – 100 years, and it could be argued that it is unlikely that today’s investors  will need to use the lessons of what went wrong this time, although historians will. This article attempts to identify the general lessons that investors can take away from the events of 2008-09, and which will have relevance over the rest of their investing life.

1)    Debt and Bubbles

The first lesson is that explosive growth of cheap debt always leads to asset price bubbles which end up bursting. In this cycle this is most clearly seen in two areas; first in the US housing market where the Federal Reserve’s response to every downturn of interest rate cuts in order to boost US consumer borrowing and spending, added to a politically-inspired drive to spread wealth by encouraging the poorer sections of the community to become property-owners, combined with a data set that showed that average US house prices had never declined on year-on-tear basis. All these factors combined to create an illusion that there was no downside to a) borrowing money to buy a house and b) lending money to buy a house. Not surprisingly, individuals rushed to borrow and buy and institutions rushed to compete to lend to them – house prices rose sharply, until the bubble burst when they fell sharply. In the poorer parts of the US, many houses are literally worthless or have negative values where sellers will pay buyers to offload properties because they come with ongoing liabilities to property taxes.

The second area in which this was seen was the “shadow banking” sector which grew substantially over the middle part of the decade. This consisted of special vehicles owned and constructed by banks but not consolidated onto their balance sheets and thus not subject to regulatory capital requirements and also of hedge funds which grew sharply in terms of numbers, assets under management and the degree of leverage they used in their strategies. These vehicles had access to very cheap funding which they used to purchase massive amounts of securitised and structured investments of such complexity that few investors could understand. In the same way as with housing, when the easy credit stopped and they tried to sell these investments they found that all the other buyers were in the same position as they were and were also looking to sell. The prices of securitised and structured debt collapsed totally as the bubble burst.

The Crash of 1929 also originated as rampant margin trading and the use of holding companies with debt on top of financial vehicles were key features of the stock market in the late 1920s, before the debt was no longer available and investments for which there had previously been only buyers, suddenly found there were only sellers.

The lesson is clear, any time credit is easy to access and historically cheap, it will lead to the inflating of a bubble in some asset class prior to its bursting. The problem with preventing bubbles is that so many people benefit from them whilst they are inflating that no one is able to get enough political will to deflate them before it is too late.

2) Panic early or not at all

The second lesson for investors is this, if you are going to panic, panic first and before the bad news is out. In hindsight, the first signs of problem for credit markets were actually seen in late 2006/early 2007 when HSBC announced provisions for credit losses in US consumer financing business, this was followed by cracks in money market funds in the summer of 2007 and the collapse of Northern Rock in September 2007. All these events markets coped with without undue upset and in fact many markets went to new highs in October 2007. Banks started to announce losses from late 2007 but were able to keep investors calm by raising as much new capital as they had written off old capital. Then Bear Stearns collapsed and was rescued and taken over by J P Morgan – this sparked a rally as investors decided that it meant that no serious bankruptcy would be allowed in US the banking sector and markets were within 10% of their October 2007 peaks by the early summer of 2008. Looking back there were of lot small warning signals that all was not well, but the market participants chose to ignore them or not to believe they were significant. However, it was not until early October as it became clear that the Royal Bank of Scotland and the Halifax Bank of Scotland would go under and probably cause the collapse of both the UK and the world’s banking systems, without the support of the government. By the time this news was public, the FTSE 100 Index was already at 4,000 and very close to the lows of the bear move apart from a few days in early March. So by the time that the seriously bad news which led to investors panic-selling their equity holdings, was splashed across the media, it was far too late to sell and indeed investors should have been considering buying rather than selling. The time to panic as an investor then was at the early stages when there were hints that all was not well within the banking system, but when other investors still had confidence and were happy to rationalise away the negative pieces of news. To panic because there is crisis in the newspapers will almost always be a very expensive decision. To quote Baron Rothschild, a very successful investor, “Buy on the sound of cannons and sell on the sound of trumpets”.

3) Don’t go with your gut

From which follows the third lesson, which is probably the hardest of all, be very aware of your emotions when you are investing and do that with which you feel the most uncomfortable. Recent research by neuroscientists has shown that when we don’t conform to the group mindset, our brains flash us with the same sense of failure response that we receive when we make some sort of prediction that is falsified by events. By contrast if we make a prediction that is confirmed by events, the reward system of the brain is activated and we are made to feel good by a release of dopamine. This process of reward and punishment guides us as we accumulate knowledge about our environment. Thus taking an opposite view to the crowd (essential to being able to sell at high prices and buy at low prices – the key to being a successful investor) actually makes us feel bad and that we are getting things wrong and worst of all, we worry about being considered a failure.

This also explains why bubbles and crashes occur. Thinking in the same way as everyone else makes people comfortable and more certain that they are right – thus develops a ‘herd’ mentality that a price is going higher which brings in more buyers so that for some time the price does move higher, and negative news which might lead to a re-evaluation gets rationalised away very easily because changing the view to one that is contrary to everyone else (even when justified by the evidence) is emotionally very painful. Then the whole process goes into reverse, but Fear is much more infectious than Greed, and so crashes happen much more quickly than bubbles.

Even for professional investors investing on behalf of clients, this is very difficult to put into practice, even if they know it is right – for investors making decisions about their own money it is almost impossible. When this is combined with the psychological reality that the negative emotional value of any given loss of money is twice the positive emotional value of an equivalent gain of money, it is easy to see that if everyone else is selling investments because the news, endlessly replayed across today’s innumerable media outlets, then individual investors will do so too, first to feel the positive experience of doing what other people are doing but secondly to avoid the painful possibility of further losses. The experience at Kleinwort Benson was that those clients who demanded to be sold out of their investments (against advice) did so between October 2008 and February 2009. Our clients would be typical and it shows that by March 2009, effectively there were few sellers left in the market. It only needed a small number of buyers to move prices higher again as the newsflow improved from the cataclysmically bad, through the merely dreadful and plain bad to past the worst. Emotionally, our clients generally felt and still feel happy that they sold out, in financial terms however it was a very expensive mistake as equity markets rose some 50% in just six months. As markets rose over the summer and autumn, so the confidence that our clients felt in going back into markets rose,, but for most the index levels at which they bought back were noticeably higher than the index levels at which they had sold out. Again, in terms of emotional health, our investors felt quite happy but in terms of financial health, it was costly.

4) Follow the Central Banks

The fourth lesson is one that has held true for most of the last 50 years and it is this. When policymakers are determined to achieve a particular outcome, be it lower growth and inflation or higher growth and inflation, the wisest course for the investor is to invest on the basis that they will succeed. In America this is usually summarised as “Don’t fight the Fed”. In particular changes in monetary policy – movement in interest rates, currencies and Quantitative Easing programmes – when applied consistently and in such a way that the markets believe in the policymakers’ determination, will be successful. The normal economic cycles seen since the 1970s showed this very clearly, once policymakers convinced the markets that they were worried about inflationary pressures and set about anti-inflationary policies (usually increasing interest rates significantly), then it made sense for investors to assume they would be successful. Similarly, once it became clear that recessionary forces in the economy were too strong, and policymakers wanted to boost growth, then it made sense for investors also to assume they would be successful. Interestingly, it often took investors a little while to determine that policymakers were serious and so typically it was only on about the third interest rate change in either direction that marked the turning point for markets. In 2008-09, there were very real fears that the policymakers could not cut interest rates by enough to be successful because 0% is effectively as low as rates can be cut. But the Central Banks, led by the Bank of England, demonstrated that they would do “whatever it takes” to save the financial system, by very substantial Quantitative Easing programmes. They may have caused controversy, but they were successful in reliquefying the global banking system and supporting all financial markets, which enabled a recovery to begin. Truly determined policymakers will achieve their goals; only the Japanese in recent years have failed this maxim and that, arguably, is because the policymakers there were not all that determined to achieve their goals.

5) Regulation is never smart enough

The final lesson to draw is almost the opposite of the previous lesson, and it is that the regulators are never smart enough to stop the excesses of the financial markets. Firstly, regulators in general work by issuing rules, in which things get defined in ways which make sense initially, but due to their very definition become distorted over time by innovation. The Basle II rules on bank capital adequacy are a classic case in point. Two definitions which were clear at the time they were first written, were “gamed” by the world’s banks for their own advantage, which in turn contributed greatly to the collapse of the banks in 2008.

First was the definition of capital, which was originally written to include ordinary and preference shares, at the time most people’s understanding of equity capital. However the definition was sufficiently vague that in time a great deal of hybrid debt was issued by banks, which had the marvellous characteristics of counting as equity capital in the eyes of the banking regulators, but counting as debt in the eyes of the end-investors, the auditors and, amazingly, the taxman. In the good times, this enabled banks to make even more profits and even higher return on equity, but in the bad times banks were reluctant to default on these securities fearing it would affect the demand for their debt, instead they had to go to their governments for true equity capital.

Second was the definition of risk-weighted assets. Banks assets that are rated “AAA”, quite reasonably require far less capital to support them that much riskier assets. This made it remarkably attractive to hold “AAA”- rated assets, particularly if they also gave above –average returns. The financial market innovators, like Nature, hate a vacuum, and so were created securitised loan packages that gave attractive returns that were also rated “AAA”. The flaw in the system was that the companies that calculated the ratings were private-sector, profit-maximising companies whose revenue streams came from those to whom the ratings were given rather than those who actually made use of the ratings in their investment decisions. The banks wanted these securities to have “AAA” ratings and could offer substantial amounts of business to those companies who would give such ratings, but not to those companies who would not give such ratings. Other investors in the financial system relied upon the rating systems of these companies without having to pay for this set source of value in their investment decision. It is perhaps not surprising that we now learn that the ratings companies made some over-optimistic key assumptions, particularly around the default rate and likely loss rates in US residential mortgages. It was the losses in “AAA”-rated securities that caught the banking system unawares because that was not seen as an area of potential risk. Its origins however lie in an enterprising private sector attempting to make the greatest profits given a set of defined regulations. In this situation the regulators will always be behind the private sector in understanding the risks of what is being done, apparently within the rules.

History never repeats itself but it often rhymes – the lessons above are generic, but the context in which they will need to be applied in the future will undoubtedly look very different from the experience of the last few years.