Nine Lessons Relearned From The Financial Meltdown

Plus ça change, plus c’est la même chose.

Exactly, one year ago Lehman Brothers collapsed, triggering a worldwide financial meltdown that threw millions out of work and devastated the retirement savings of many more millions. One year later, the economy and the stock market have recovered from the near-death experience, though not fully just yet. While some aspects of the financial crisis were surprising, many of the lessons of are timeless and shouldn’t be surprising at all:

Live within your means. If there is a golden rule in personal finance this is it — spend less than you earn. Unfortunately, many had forgotten this basic rule, lulled into complacency by sunny skies, easy credit and a distant memory of the previous recession. Our savings rate was negative and many were unprepared to handle tough economic conditions. It doesn’t seem that this lesson has still sunk in — a depressing recent report suggested that Canadians have trouble establishing a savings habit.
Keep an emergency fund. For me, this is the most important lesson of the financial crisis. I had believed earlier that a line of credit can serve as an emergency fund but not anymore. Though it never actually came to that, this crisis has amply demonstrated that a line of credit could be cut back or even become unavailable in a serious financial crisis — precisely when we may need a credit line the most. Now, I think a stash of cash that will cover three to six months of expenses is absolutely essential, despite the low returns and tax inefficiency of cash holdings.
Use leverage responsibly. Back in 2007, leverage was very fashionable. Credit was cheap and plentiful and the TSX had returned an average of more than 20% for four years and for many, it seemed a no-brainer to borrow at a net of 3% and earn double-digit returns in the stock market. The stock market crash has exposed the risks in such a strategy — it is hard enough watching your own savings evaporate; it must be excruciating to think that you have to make up the difference to a lender. Leverage is unavoidable in certain cases such as buying a home or getting an education but still it must be approached with caution.
A home is not an investment portfolio. With home prices trending upward year after year, a lot of investors fell into the trap of thinking of their home as an investment that could somehow be used to fund a retirement. The collapse of home prices in the United States is once again a reminder that homes are not immune to price corrections and it is best to think of a home as simply a place to live and raise a family — any price appreciation is simply a bonus.
Stock markets can go down in a hurry. Benjamin Graham wrote in The Intelligent Investor: “In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say, 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” Somehow, investors are surprised when stocks do just that.
Bonds have an important place in a portfolio. As unsexy as bonds are in bull markets, they really shine when stocks drive off a cliff. Firstly, bonds cushion the fall of stocks in a portfolio. Second, they enable an investor to take advantage of low stock prices through rebalancing. Note that bonds here refer to Government bonds, not corporate bonds, which historically have a high correlation with stocks. In the stock market panic of 2008, corporate bonds offered no protection and dropped just like stocks.
Asset allocation still works. The widespread reports on the death of asset allocation are vastly exaggerated. It is true that stocks fell in lock step around the world. However, bonds, as noted earlier, held up their value and cushioned the fall in stock prices. That is exactly how we expect asset allocation to work — reduce the risk of a portfolio by adding asset classes that don’t move in sync together.
Market timing still doesn’t work. The S&P 500 opened at 1,250 on that fateful morning on September 15, 2008. It closed at 1,049 yesterday for a loss of 16%. Add in dividend payments and you are probably looking at a modest loss. It didn’t always look that way. At one point, stocks would have been down by 47% and the market timers came out of the woodwork claiming that investors could have avoided the entire mess by following their timing model. The critical question though is: how many got back into stocks to take advantage of this rally?
Do not load up on company stock. It is like watching the same horror flick over and over again. Every time a company fails, you read press reports of employees who have lost their job as well as their life savings. It happened with Bear Stearns; it happened with Lehman Brothers and probably every other company that filed for bankruptcy in the past year. We already depend on our employer for a paycheck; it doesn’t make much sense to compound the risk by investing our savings in our employer as well.