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The Forgotten Lessons of 2008
The four most dangerous words in investing are, “This time is
different.”
Hands down, our favorite quote on investor’s lack of
historical memory comes from Jeremy Grantham who, when asked “Do you
think we will learn anything from this turmoil?” responded, “We will
learn an enormous amount in the very short term, quite a bit in the
medium term and absolutely nothing in the long term. That would be the
historical precedent.”
In this spirit, we highlight the lessons
that should have been learned from the turmoil of 2008, complements of
Seth Klarman. The excerpt below is from his annual letter. While most
market participants have immediately forgotten these lessons, more
prudent investors (who may still suffer from short term memory loss)
should consider dusting this list off on an annual basis!
Twenty
Investment Lessons of 2008
1. Things
that have never happened before are bound to occur with some
regularity. You must always be prepared for the unexpected, including
sudden, sharp downward swings in markets and the economy. Whatever
adverse scenario you can contemplate, reality can be far worse.
2. When excesses such as lax lending standards become
widespread and persist for some time, people are lulled into a false
sense of security, creating an even more dangerous situation. In some
cases, excesses migrate beyond regional or national borders, raising
the ante for investors and governments. These excesses will eventually
end, triggering a crisis at least in proportion to the degree of the
excesses. Correlations between asset classes may be surprisingly high
when leverage rapidly unwinds.
3. Nowhere does it
say that investors should strive to make every last dollar of potential
profit; consideration of risk must never take a backseat to return.
Conservative positioning entering a crisis is crucial: it enables one
to maintain long-term oriented, clear thinking, and to focus on new
opportunities while others are distracted or even forced to sell.
Portfolio hedges must be in place before a crisis hits. One cannot
reliably or affordably increase or replace hedges that are rolling off
during a financial crisis.
4. Risk is not inherent
in an investment; it is always relative to the price paid. Uncertainty
is not the same as risk. Indeed, when great uncertainty – such as in
the fall of 2008 – drives securities prices to especially low levels,
they often become less risky investments.
5. Do not
trust financial market risk models. Reality is always too complex to
be accurately modeled. Attention to risk must be a 24/7/365 obsession,
with people – not computers – assessing and reassessing the risk
environment in real time. Despite the predilection of some analysts to
model the financial markets using sophisticated mathematics, the
markets are governed by behavioral science, not physical science.
6. Do not accept principal risk while investing short-term
cash: the greedy effort to earn a few extra basis points of yield
inevitably leads to the incurrence of greater risk, which increases the
likelihood of losses and severe illiquidity at precisely the moment
when cash is needed to cover expenses, to meet commitments, or to make
compelling long-term investments.
7. The latest
trade of a security creates a dangerous illusion that its market price
approximates its true value. This mirage is especially dangerous during
periods of market exuberance. The concept of “private market value” as
an anchor to the proper valuation of a business can also be greatly
skewed during ebullient times and should always be considered with a
healthy degree of skepticism.
8. A broad and
flexible investment approach is essential during a crisis.
Opportunities can be vast, ephemeral, and dispersed through various
sectors and markets. Rigid silos can be an enormous disadvantage at such
times.
9. You must buy on the way down. There is
far more volume on the way down than on the way back up, and far less
competition among buyers. It is almost always better to be too early
than too late, but you must be prepared for price markdowns on what you
buy.
10. Financial innovation can be highly
dangerous, though almost no one will tell you this. New financial
products are typically created for sunny days and are almost never
stress-tested for stormy weather. Securitization is an area that almost
perfectly fits this description; markets for securitized assets such
as subprime mortgages completely collapsed in 2008 and have not fully
recovered. Ironically, the government is eager to restore the
securitization markets back to their pre-collapse stature.
11.
Ratings agencies are highly conflicted, unimaginative dupes. They are
blissfully unaware of adverse selection and moral hazard. Investors
should never trust them.
12. Be sure that you are
well compensated for illiquidity – especially illiquidity without
control – because it can create particularly high opportunity costs.
13. At equal returns, public investments are generally
superior to private investments not only because they are more liquid
but also because amidst distress, public markets are more likely than
private ones to offer attractive opportunities to average down.
14. Beware leverage in all its forms. Borrowers – individual,
corporate, or government – should always match fund their liabilities
against the duration of their assets. Borrowers must always remember
that capital markets can be extremely fickle, and that it is never safe
to assume a maturing loan can be rolled over. Even if you are
unleveraged, the leverage employed by others can drive dramatic price
and valuation swings; sudden unavailability of leverage in the economy
may trigger an economic downturn.
15. Many LBOs
are man-made disasters. When the price paid is excessive, the equity
portion of an LBO is really an out-of-the-money call option. Many
fiduciaries placed large amounts of the capital under their stewardship
into such options in 2006 and 2007.
16. Financial
stocks are particularly risky. Banking, in particular, is a highly
leveraged, extremely competitive, and challenging business. A major
European bank recently announced the goal of achieving a 20% return on
equity (ROE) within
several years. Unfortunately, ROE is highly dependent on absolute
yields, yield spreads, maintaining adequate loan loss reserves, and the
amount of leverage used. What is the bank’s management to do if it
cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the
risk of loss? In some ways, for a major financial institution even to
have a ROE goal is to court disaster.
17. Having
clients with a long-term orientation is crucial. Nothing else is as
important to the success of an investment firm.
18.
When a government official says a problem has been “contained,” pay no
attention.
19. The government – the ultimate
short-term-oriented player – cannot withstand much pain in the economy
or the financial markets. Bailouts and rescues are likely to occur,
though not with sufficient predictability for investors to comfortably
take advantage. The government will take enormous risks in such
interventions, especially if the expenses can be conveniently deferred
to the future. Some of the price-tag is in the form of backstops and
guarantees, whose cost is almost impossible to determine.
20.
Almost no one will accept responsibility for his or her role in
precipitating a crisis: not leveraged speculators, not willfully blind
leaders of financial institutions, and certainly not regulators,
government officials, ratings agencies or politicians.
Below,
we itemize some of the quite different lessons investors seem to have
learned as of late 2009 – false lessons, we believe. To not only learn
but also effectively implement investment lessons requires a
disciplined, often contrary, and long-term-oriented investment approach.
It requires a resolute focus on risk aversion rather than maximizing
immediate returns, as well as an understanding of history, a sense of
financial market cycles, and, at times, extraordinary patience.
False Lessons
1. There
are no long-term lessons – ever.
2. Bad things
happen, but really bad things do not. Do buy the dips, especially the
lowest quality securities when they come under pressure, because
declines will quickly be reversed.
3. There is no
amount of bad news that the markets cannot see past.
4.
If you’ve just stared into the abyss, quickly forget it: the lessons
of history can only hold you back.
5. Excess
capacity in people, machines, or property will be quickly absorbed.
6. Markets need not be in sync with one another.
Simultaneously, the bond market can be priced for sustained tough
times, the equity market for a strong recovery, and gold for high
inflation. Such an apparent disconnect is indefinitely sustainable.
7. In a crisis, stocks of financial companies are great
investments, because the tide is bound to turn. Massive losses on bad
loans and soured investments are irrelevant to value; improving trends
and future prospects are what matter, regardless of whether profits
will have to be used to cover loan losses and equity shortfalls for
years to come.
8. The government can reasonably
rely on debt ratings when it forms programs to lend money to buyers of
otherwise unattractive debt instruments.
9. The
government can indefinitely control both short-term and long-term
interest rates.
10. The government can always
rescue the markets or interfere with contract law whenever it deems
convenient with little or no apparent cost. (Investors believe this now
and, worse still, the government believes it as well. We are probably
doomed to a lasting legacy of government tampering with financial
markets and the economy, which is likely to create the mother of all
moral hazards. The government is blissfully unaware of the wisdom of
Friedrich Hayek: “The curious task of economics is to demonstrate to
men how little they really know about what they imagine they can
design.”)
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I didn't forget, I am just hoping for one more mega bubble in alternative energy so I can retire in Crete, swim, suntan, eat, and spend my drachmas.:)
An observation:
Knowing when the game is about to end changes all investing scenarios. We are there. It's time be be sure your Derringer is loaded.
'9. You must buy on the way down.'
NO WAY !
Averaging down is foolish.
Only buy stocks in a rising market.
The difference between a 'trader' and an 'investor'.
DeVoe has been touting a good one for years: more money has been lost reaching for yield than at the barrel of a gun.
Great stuff.
I would add one more...never underestimate Man's insatiable appetite to obtain something for nothing.
+1. Agree.