I can hear an audible sigh of relief from many investors, particularly retirees, with the improvement on the share market in recent months. It has been a long, arduous journey over the past 6 years and you can be forgiven for embracing the thoughts of many economic commentators that the worst may be behind us.
Before we consign the GFC to the history books (and I'm not sure this is wise as we are far from out of the woods yet), or endeavour to erase these memories, it is wise to reflect on what we have learnt from the GFC so we don’t repeat the mistakes.
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| Iman Mosaad |
We as humans do evolve in so many ways, except when it comes to this. Logic takes a back seat and we embrace the “new paradigm” where lessons learnt from the past don’t apply anymore.
But stretch the memory back and we can see that the world does move in cycles and bubbles form and they burst. The GFC is just the more recent of many examples of this.
If you don’t accept the anecdotal evidence, have a read of a book by Reinhart and Rogoff (called you guessed it, “This Time is Different”) if you want the hard empirical and academic evidence. It doesn’t read like a David Baldacci novel, so to save you some toil, here are some of the findings from this study:
Evidence of The Bubble forming
• Real estate prices are the initial element of many bubbles that form (the converse is they are a good predictor of future bubbles).
• From 1996 – 2006, cumulative real price increase in US house prices was about 92% - more than 3 x the whole period from 1890 – 1996.
• New markets are formed, new financial instruments are created (eg securitised lending) and new lenders are found.
• Massive increases in leveraging within the banking system around the world. Borrowing money is dead easy.
What Can we Expect Following a Financial Crises?
• There have been 18 Bank centered financial crises since WWII. These are not rare events (although this was one of the worst).
• Following a severe financial crises asset market collapses are deep and prolonged. The decline in real housing prices average 35% over 6 years and equity prices 56% over 3 ½ years.
• Economies suffer a decline in output and employment.
• Government debt explodes (can anyone please tell me what comes after a trillion and we will let the US Federal Reserve know?).
So there are common elements and conditions that lead to bubbles forming and we are not too good at predicting when bubbles are going to burst, despite evidence that will build and be presented before us, and then seem obvious after the event!
Lesson 2 Fear versus Greed
One of the basic tenements of investor psychology is the fear and greed factor and how it effects the decisions we make. If we were unemotional, logical, patient types of beings, we would without question be far more successful investors.
So why do we get so carried away during periods like the dotcom boom and more recently, the GFC? As Gordon Gecko famously pronounced in the movie Wall Street, "Greed is good!"
Contrary to what the great man said, greed is actually not so good. It explains why the vast majority of investors clime on board and buy at the top of markets, rather than near the bottom.
So why do these cycles usually end so quickly and viciously?
Whatever the reason for the bubble being pricked, once it does, fear takes over.
Fear is what drives down markets as on mass, people sell their investments. People have frequently bought investments blindly ignoring risk (the greed factor) and then suddenly they are far more risk averse than they realised.
Investing is counter-intuitive. You should be buying when you don’t want to buy and selling when you don’t want to sell. Recognise this, remember this and try to be less emotional when it comes to making major investment decisions.
Lesson 3. DEBT – The “Dead Money” Myth
Any borrowing, leveraging or gearing (all means the same thing) means far greater risk. As we saw with Storm Financial, it not only means a risk of losing money on your investment, but a risk of losing your house, or whatever other asset that has been used as security.
From a financial adviser viewpoint, it tends to be sold as a tax driven strategy, as the interest cost is tax deductible. A certain level of gearing is not such a bad thing. The massive amount of gearing, due to the easy money that has been available over the past 10 + years, is bad.
Being able to borrow over 100% of the value of a property is not a good thing. Having no savings history and then gearing heavily is not a good thing. No income, no job, no asset loans (i.e. the NINJA loans emanating from the US and the low doc loans that were starting to gain a footing in Australia) are not a good thing. Owning 10 properties in 12 months and being a paper multi-millionaire (well in assets anyway, lets conveniently ignore the debt), despite what the white shoe brigade on the Gold Coast tell you, is risky.
Lesson 4 Alternative Assets
I have used this term to describe the proliferation of products that invest in non-traditional asset classes. i.e. assets other than shares, real estate, fixed interest, cash and commodities.
The best example of this, and will likely be featured in University texts and case studies for a long time to come, is the financial wizardry behind the packaging and selling of US sub-prime mortgages.
Billions of dollars of these securities were sold around the globe. Some of the players knew they were a time bomb waiting to go off but still sold them. As we have seen, house prices plummeted, the securities became virtually worthless and almost brought down the whole world financial system with it.
There is an old investment cliché, “don’t invest in something you don’t understand”. If the investment is mostly based on investing in traditional assets, but use other financial instruments to reduce risk then it is probably worth further investigation. If it's an investment in just financial derivatives promising a far superior return than what you can get in the “real” market, I would be very wary. It is usually the bankers who are going to do well out of this, not you.
The GFC has been caused by an explosion in debt. The solution from the economic guru’s has been to create more debt. We do have short memories but I find it extraordinary a number of “experts” predict good times ahead. I don't think we have learnt from the GFC at all, and it hasn’t finished yet!
Aaron McCracken
Private Client Adviser
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