Nick Foy, CFP®
Last week marked the tenth anniversary of the collapse of Lehman Brothers, which, along with the forced sale of Merrill Lynch to Bank of America, and the federal takeover of Fannie Mae and Freddie Mac, triggered the Dow Jones Industrial Average to plunge almost 4.5% that day. Two weeks later, an even bigger 7% drop signaled the spread of the financial crisis, as Lehman’s $613 billion in debt reverberated throughout the financial market. Their bankruptcy remains the largest in history.
Shortly thereafter, Washington Mutual was seized by the FDIC, and their assets were sold to JP Morgan Chase, and Wachovia was acquired by Wells Fargo.
Debt markets froze up, housing prices plunged, and individual investors faced countless sleepless nights as they watched the value of their portfolios deteriorate over then next five months, until the market bottomed out in early 2009.
As a Vanguard crew member from 2007-2011, I was in a position to speak with thousands of clients before, during, and after the financial crisis, and experienced first hand the type of reactions that real people were having to the headlines. It wasn’t pretty.
To make matters worse, our tendency is to react emotionally instead of logically to market movements, and clients were watching their nesteggs evaporate into thin air. For many, the fear of the continued meltdown was too much to bear, and they abandoned their long-term investment strategies in favor of what they perceived to be safer waters.
Cash flows out of mutual funds accelerated as investors withdrew $49 billion from stock funds in September 2008 and another $55 billion in October.
In March of 2009, the market started its rebound. The upward movement was even more violent than the initial drop, and many investors who sold low never bought back in. Instead, they forever locked in their losses and missed the upward swing and subsequent unprecedented bull market. Those who did re-invest in equities waited until prices had recovered, as is the pattern most individual investors tend to follow: Sell low, buy high.
The roots of the financial crisis are numerous: Government’s desire to make housing affordable to those who probably can’t afford homes. Wall Street’s ability to securitize just about anything. Ordinary people believing the lie that a home is always a great investment.
But anyone with even a smidgen of understanding about the history of markets, and a basic comprehension of investment theory would know that every once in awhile, markets go mad about something. However, the ability to absorb losses without overreacting, or making choices that aren’t in your own best interest is difficult to do.
Three ways to prepare for the next downturn
Based on my experience working with thousands of individual investors, and my study of markets, here are three ways to avoid making a poorly timed bad decision:
- Design your portfolio ahead of time. Historically, there has been a linear relationship between the amount of stock in a portfolio, and the amount of risk/return one can expect. Selecting an appropriate allocation in equities; taking on enough risk to earn a sufficient rate of return over and above inflation without taking on so much risk that the money won’t be there when you need it if your cash flow needs are more immediate.
Very few self-directed investors get this right. Many clients I worked with were focused on all the wrong things, like recent past returns for a specific fund.
I very distinctly recall talking to a client in mid-2007 who wanted to move 100% of his portfolio into the Vanguard Emerging Markets fund. From 2003-2007, the fund returned: 57%, 26%, 32%, 29%, and 38% respectively. This client was obviously impressed with the return history, and wanted to be a part of it. Unfortunately, you can’t buy past returns.
I tried to talk him out of it, stressing the need for broader diversification and the risk inherent investing in emerging markets stocks. He ignored my pleas, and made the shift.
In 2008, the MSCI Emerging Markets Index, and the Vanguard fund, plunged over 50%.
I never talked with that man again, but my guess is that at some point during the downturn, he modified his portfolio yet again, and might even have moved everything to cash. If he’s like the average individual investor, he probably did.
In 2009, the fund was up almost 76%.
Choosing an appropriate allocation is such a significant first step, and would’ve helped him (and so many others) avoid the see-saw, providing a better investment experience.
- Get some accountability. This is what solid advisors get paid for: designing a suitable portfolio is only part of it. The next (perhaps more) important step is ensuring that client doesn’t do something drastic, and can maintain a focus on the longer-term plan. Advisors who get paid to sell products aren’t as concerned about this; their sale has already been made. Their incentive is to sell the client a different strategy, and profit once again. Only advisors who get paid a fee for their advice are appropriately incentivized to offer accountability.
Without accountability, the emotion of managing your own portfolio can overtake the logical implications of maintaining an appropriate investment strategy.
- Focus on what you can control. Investing costs. Taxes. Risk. Broad diversification. Those are the things we have control over.
We know that markets go berserk every so often; it’s not if, it’s when. We have no control over the broader market. We do, however, have control over the way we react to the madness.
We can easily diversify away non-systematic risks. Individual industries or businesses can fail. Individual countries or regions can face significant headwinds. Work to own a portfolio that eliminates all form of non-systematic risk, and can only go to $0 if Armageddon happens. It’s easy to diversify broadly for very little cost, and the science of investing tells us that broad diversification reduces risk, and gives investors a better chance of success.
Lessons learned from my experience in working with self-directed investors, despite being anecdotal, confirmed the research and work being done by neuro-economists into investor behavior. Separating the emotion of investing from the scientific evidence is always difficult, especially when the market misbehaves.
Learning from others’ past mistakes is a much more efficient education than re-creating them for ourselves.