Must Read: Seth Klarman On The True And False Lessons From The Financial Crisis, Blasts Government Market Intervention

Tyler Durden's picture

Via Value Investing Insight. Absolute must read for a new investing generation which really does think that this time it is different (and will not end in tears). Pay special attention to the False Lessons, which blare at you daily as the one true gospel by the likes of CNBC.

In this excerpt from his annual letter, investing great Seth Klarman describes 20 lessons from the financial crisis which, he says, “were either never learned or else were immediately forgotten by most market participants.”

One might have expected that the near-death experience of most investors in 2008 would generate valuable lessons for the future. We all know about the “depression mentality” of our parents and grandparents who lived through the Great Depression. Memories of tough times colored their behavior for more than a generation, leading to limited risk taking and a sustainable base for healthy growth. Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior. One state investment board recently adopted a plan to leverage its portfolio – specifically its government and high-grade bond holdings – in an amount that could grow to 20% of its assets over the next three years. No one who was paying attention in 2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 melt- down; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

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 fin-ancial 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 back- stops 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.”)

h/t Mungerisms

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Jim in MN's picture

Here's a market solution for Greece: Senior German politicians call for selling Agean islands...perhaps confiscating them from the super-rich to sell to others (oh that's not as market-friendly is it)...



mule65's picture

The markets are just like golf:  When you think you got it figured out you're really in trouble.

B9K9's picture

virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

The operative word is 'most', for without this qualifier, the entire premise of the article is completely incorrect.

To interpret the level of outright fraud, corruption & market manipulation as some irrational behavior based on lessons never learned or forgotten is astoundingly naive.

The people who are (still) moving the markets, and have been setting the tone for hundreds of years, not only never forgot their lessons, they learned at the feet of masters.

I have come to the conclusion that the serfs really deserve their fate; they are simply too stupid to warrant anything better. It is so utterly transparent to see how these situations are played out over & over again to each new generation; the never ending 3-card monte trick.

The only downside to being a MOTU is the complete & utter boredom. Where do the financial masters get the energy to endlessly repeat the same set of exercises? Aren't they bored to tears? This is why artists & scientists will often forego material rewards just to have the opportunity to pursue something presently unexplored or which they find personally interesting.

From an evolutionary stand-point, this is a real weakness. Take two individuals of comparable IQ, one intellectually curious, but the other completely nihilistic. How do the artists & scientists compete? Answer: they don't; they get crushed along with everyone else. Their only advantage (?) is knowing what is happening and to make certain preparations to survive the coming shit storm.

In the meantime, please refrain from the "lessons not learned" schtick. The real underlying truths have been drilled into the players' heads for generations. They haven't forgotten the most important fact of all: people are dumb, and they deserve to be raped.

Anonymous's picture

"They haven't forgotten the most important fact of all: people are dumb, and they deserve to be raped."

While I agree that people can be dumb, it doesn't follow that they deserve to be raped for it. However, it is true that it's easier to rape someone who is dumb. That is the lesson the MOTU and other criminals get. Certainly, they might also rationalize that dumb people deserve to be raped. Though that is likely merely to satisfy the weak protests of their own underdeveloped sense of justice.

Anonymous's picture

Greatest investor in history.

RobotTrader's picture


Let me simply it some.....


1) Fundamentals are to be ignored entirely.

2) Its all about motion chasing and momentum

3) All losses are to be cut immediately

4) It its going up, buy it.  If its going down, sell it or short it.

5) Trading stocks and following trends is now like a greyhound following a meatball.  Most 17-year old video gamers can do this perfectly.


chindit13's picture

I'll steal from my comment on the Fed Balance Sheet article and add to your list:

6)  Let ye who is without sin pay for everyone else.

7)  Never address today what you can pass off to the next generation.

8)  There is no such thing as a bad debt.  There are only bailouts-in-waiting.

9)  If at first you don't succeed, spend and spend again.

10)  Red futures at night, traders' delight;  red futures in morning, PPT take warning.

dumpster's picture

good read thanks


sinclair take .. on the going ons

Not one word we hear is truthful. Finance has been totally degraded, and the sheeple so far don’t really care.

The problem with this is that when the reckoning arrives, which it will, it will come like the Four Horsemen of the Apocalypse.

Truly MOPE is a set up for the end of financial days

Oracle of Kypseli's picture

Yes! great lessons, but still....

Combine "chaos theory," "irrational exuberance," "heard mentality," "momentum investing" "friendly trend" add the fear and greed factors, stir with a dash of short term gambling and you have a deadly cocktail. 


Dehrow's picture

I concur.

I especially like the bold ones, they are particularly insightful. However, until society learns these lessons, the teachings will be to the benefit of only a few. Who knows, maybe once these lessons are learned, a whole new batch will need to be learned.

SP<600, here we come.

illyia's picture

Hey Tyler. I saw your movie the other day.

You were really good!


Anonymous's picture

"Yet one year after the 2008 collapse, investors have returned to shockingly speculative behavior..."

That's because people have turned their money over to mutual funds and no longer have direct control. Fund managers have returned to shockingly speculative behavior, but people are obliviously along for the ride. These are hardly investors.

faustian bargain's picture


Wish more people were this thoughtful, especially in the media.

BlackBeard's picture

Klarman has a pretty good book out.  Out of print tho.

godfader's picture

Why are performance numbers for Baupost for 2007/2008 and especially 2009 so hard to get? I couldn't find them anywhere.

bruiserND's picture

11) this was a crisis by design

12) Not even FOX news was capable of telling the truth about CDS & CDOs and breaking a story about the largest property crime in the history of civilization

13) The Baader Meinhoff gang was right after all.


theprofromdover's picture

I think Nassim Taleb needs to write another chapter.

As well as Black Swans, there are Thanksgiving Turkeys.

A Thanksgiving Turkey can * be induced to appear just after a Black Swan, when those in power move the goalposts and change the rules of the game to fix the result in their favour.

* as in 'will always be the case from now on'

I think if every time Roubini makes a valid dire prediction, he just should preface it with 'unless the T-T appears, the following will happen. He might get a better hearing.

brodix's picture

Life is a bubble. We don't build for the walls, but the spaces they create, but if you build poorly, the spaces get smaller quickly.

godfader's picture

Can the team at Zerohedge post annual performance numbers for Baupost's flagship fund for 2007, 2008 and 2009? TIA.

Anonymous's picture

thats a big bunch of bulls...PROPAGANDA - JUST LOOK AT JAPAN or the lost 2 decades 60s to 80s being in stocks lost you tons of money in real terms

Anonymous's picture

12. Free Bernie.

Anonymous's picture

Here it is....

Without doubt....the problem is one of tax structure....

What would be a proper tax structure ?

This begs the question of fairness....

Answer the question....

Should one pay for what one uses ?

Now answer this question....

Should one pay for what one does not use ?


Next question....

Should any family of four ....spend more than it earns ?


Next should tax revenues be spent ?


Next question ....

What structure would create conditions such that manufacturing would be rapidly re-established in the US such that when one walked into would be buying US made goods ?


Answer....15% Consumption tax

No individual or corporate taxes....

Each township....state by state would vote via internet as to how revenues are spent....(not lobbyists)


Next question....

Would the tax revenues of a 15% consumption tax be exponentially higher in 10 years than the soon to be annopunced VAT which will be added to individual and corporate well as in addition to state taxes....?

Answer...the tax take from a sole 15% consumption tax would be exponentially higher than the current and proposed tax structure....

Would there be higher or lower employment under a 15% sole consumption tax ?

Answer....there would be labor shortages


My friends....time to hit the reset button....

blindfaith's picture

Of course all who read Zerohedge don't need to be told this.  And, those who don't, won't.

Lessons learned by the


A friend who has LOST 6 income rentals in Key West, his business and now soon his residence, plans to "JUMP BACK INTO" the market as soon as he sells his house (if the bank doesn't get it first).  Can't tell him a thing.  And, what is his favorite show?  Why CNBC of course.  He Says he "finally understands the market, he didn't before".  Sad.

Cognitive Dissonance's picture

"......Can't tell him a thing.  And, what is his favorite show?  Why CNBC of course.  He Says he "finally understands the market, he didn't before".  Sad."

Any market ultimately feeds off the greater fool. And greater fools are (self) created by denial. No one needs to convince the greater fool that he (she) is a greater fool. He does it to himself, often willingly and gladly.

Sad indeed.

DavosSherman's picture

says it all super read

Anonymous's picture

> False Lessons
> ...
> 4. If you’ve just stared into the abyss,
> quickly forget it: the lessons of history
> can only hold you back.

If your gonna quote Nietzsche, I can't resist commenting:

While I was looking for that, I ran across this:

Seemed appropriate, somehow.

(PS: I got "[ ] plus one equals 35" as a captcha. Now where's my calculator so I can figure it out...)

dnarby's picture

Did anyone else have a problem with:

"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."


godfader's picture

Losers average losers.

Lux Fiat's picture

Heck yes.

If there is going to be a decent uptrend, then you should have plenty of time to make money once it is apparent the trend has changed (based on some basic technical indicators).  I know plenty of folks who decided to bottom fish in the fall of 2008.  For the most part, it didn't work out very well.  From my perspective, folks who want to capture 100% or 95% of a move will usually make a lot less than those looking to capture 60% or so.

Anonymous's picture

This rule makes sense for his investment style. Baupost puts a LOT of capital to work in relatively illiquid investments. Building a sizable position frequently requires catching falling knives. I've got some experience in this area and what he says is quite true.

I'm personally quite wary of "simple technical rules" (mentioned in another comment) and don't use them myself. But there are a lot of ways to make (or lose) money in the market, and many of the "rules" that apply to one approach are not relevant or even counter productive in another approach.

Traders don't buy dips. Value investors do. Both parties can still make money. And there are plenty of people who have tried a hybrid approach melding momentum and value approaches...with some success.

Next time you decide you want to own a couple weeks or months worth of volume of a stock, bond, loan, etc. you'll likely appreciate Seth's advice.

Anonymous's picture

there were some truly amazing bear market rallies
in the fall of 2008 ... fast and furious ...
kept me alive ...

crzyhun's picture

Quick overview/response before I read this over the weekend.

On BBerg this very morning, one their light bulbs. Hayes was her name, was interviewing a 'joker' about the wall of worry this market is climbing on. First, I almost drove off the road. Second, a time warp, and you were in 1998, same small talk, patter and jive. I am totally sure and convinced that these people believe they are right, that you can truly, really, understand Mr Market or Ms Market, whatever, and follow the same tripe and get the same results.

If we here in ZH land are insane, like we are in an institution for the insane, and out there is reality, I want none of it- out there. I'll stay with the slightly insane among us and hope for the best---prepare for the worst.

PS-Greece should sell those islands. Pronto. They seem not to get one scintilla of what they are f/g with. But then, hey it's big rock candy mountain, right comrades.


Cognitive Dissonance's picture

The diagnosis is correct, we are all insane. It's simply a matter of degree. Unlike pregnancy, it's not an all or nothing proposition.

Anonymous's picture

Thanks for a teriffic read. I think I'll print this one out and frame it for my son as a college graduation present.

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george22's picture

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.

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