**4 Lessons from the Financial Crisis

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4 lessons from the financial crisis

By Walter Updegrave, Money Magazine senior editor
November 17, 2008 5:13 pm

If you can learn from the mistakes of others, now is a great time to be an investor.

Question: I’m inexperienced when it comes to investing, but I want to build a more secure financial future. What tips or suggestions do you have for a young investor like me? —Caleb Bond, Denver

Answer: It’s a great time to be starting out as an investor. Yes, I know that might sound odd, given that the market and the economy are in shambles. But the fact that people are so fearful and the outlook is so uncertain can also have its advantages.

For one thing, much of the excess has been wrung out of stock prices over the past year or so. And while this hardly insures a quick rebound, the money you invest today is much more likely to earn a higher return than if you had invested before the meltdown.

Even more important, though, is that you now have a better sense of the real risks of investing. People who gain their investing experience during bull markets can easily be lulled into a false sense of security. They know that severe downturn occur and maybe could occur again, but the possibility of one happening to them seems remote.

Today, however, all you’ve got to do is look around you to see that risk is real, it can be devastating and it must be respected.

That said, there’s also the danger that someone surveying today’s scene might take away the wrong lessons. Already, some people are concluding that stocks, or financial assets in general, are just too risky. When it comes to important goals like retirement, they say, the experience of the last year or so shows you should stick to the most secure investments, FDIC-insured CDs and the like.

But that’s an overreaction. Risk is a natural part of investing, a part of life, for that matter. Eliminate it and you eliminate opportunity. The key is to understand how much risk you’re taking and manage it.

With that in mind, here are four lessons I think beginning investors should take from the financial crisis and apply to their investing decisions now and in the years ahead. Come to think of it, I think experienced investors should consider them as well.

Financial success isn’t just about investing.

We kind of lost sight of this fact because returns on financial assets had been so good from the early 1980s through the late ‘90s. And even after the dot-com bust we had another five-year bull run in stocks, not to mention heady gains in the real estate market. It became easy to assume that we could achieve financial goals like a secure retirement with a minimum of savings because we could count on the compounding effect of years of high returns.

That was always an unsound strategy, but it’s only now becoming clear how flawed. In fact, as a study by Putnam investments showed a couple of years ago, saving is just as important for building wealth, if not more so. We can’t be sure of the size of the investment gains we’ll earn, and we don’t have nearly as much control over them as we used to think. But we have much more control over how much we save.

And by saving more, we gain two big advantages: we don’t have to invest as aggressively to build a retirement nest egg or reach other financial goals; and, by socking more money away, we’ll have more of a cushion in the event of setbacks in the market.

Simplicity is better than complexity.

If I could ban two words from the vocabulary of investors, it would be these: “sophisticated investing.” I think more harm has been done by investors trying to boost their returns by creating arcane investing strategies or buying complicated investments they don’t understand than all the investment con men and rip-off artists combined.

I don’t want to sound like a Luddite. I’m all for using tools, calculators and software to help you create a retirement plan and an investing strategy. But you’ve also got to maintain a healthy sense of skepticism about how much fancy algorithms and intricate computer simulations can do.
Fact is, the more complicated your investing strategy is, the more things there are that can go wrong, and the harder it will be for you to monitor and maintain it. A simple mix of stock and bond mutual funds may not be the sexiest strategy around. But if you use good common sense in putting that mix together - i.e., you diversify broadly as we recommend in our Asset Allocator tool - it will serve you well over the long term.

Allow for the possibility you may be wrong.

One of the most notable features of the real estate bubble was how sure people felt that prices would continue to go up, up, up. At the peak of the housing mania, I remember getting emails from firms that were inducing individuals to open self-directed IRA accounts so that they could then invest their IRA money in real estate. I wrote a column at the time suggesting that this might be a sign that the real estate market was getting frothy and warning people about staking their retirement on the housing market.

I got a lot of feedback on that column, alas, most of it from people who wanted to know how they could get in touch with those firms that could help them get rental houses into their IRAs. And although I and others pointed out that house prices had gone down in the past and stayed down for quite a while after big run-ups, no one seemed to believe that it could happen again.

Which is why it’s always important when you’re investing to give yourself a reality check. Are your assumptions realistic? Is there something you’re overlooking? Could you be wrong? What would the fallout be if you are? And, perhaps most important, are you interested in this investment because it fits in with your overall strategy or because it’s the investment everyone is talking about? Don’t get too euphoric during upswings or depressed during downturns.

When things are going well and the economy and the markets are on a roll, it’s easy to let the excitement cloud your judgment. After all, everywhere you look - the double-digit gains in the fund listings, the upbeat news in the newspaper’s business section, the cheerful banter on cable TV financial shows - you get positive reinforcement. You almost can’t help but believe that the good times will continue to roll.

So you begin to boost the percentage of stocks in your portfolio and put more money than you should into hot investments that now seem like good bets, such as emerging market stocks. In other words, you begin taking on more risk, although, you probably don’t see it that way. How can investing be risky when it seems the market only goes up?

This process kicks into reverse, of course, when the markets and economy change course and begin falling apart. Then the prevailing gloom and doom dominates your thinking. Everywhere you look - the double-digit losses in the fund listings, the downbeat news in the business section, the somber mood and dire pronouncements on the cable TV financial shows - you get negative reinforcement.

You become convinced that the hard times will get even harder. So you sell out of stocks and move into safe-haven investments you sneered at during boom times - bond funds, money-market funds, stable-value funds, even CDs. And you no doubt see this as a move to reduce risk. After all, aren’t you safer getting out of the market when it only seems to keep going down?
But there’s a risk here too: you may be selling at the worst time and positioning yourself to miss the recovery when it occurs.

These feelings and reactions are natural. We’re human. But it’s no news flash that markets and economies move in cycles. That we go through periods of excess on both the upside and downside. We’ve gone through such episodes before and we will again. So ideally you want to set a strategy that factors in such fluctuations, and then avoid the urge to abandon your strategy when your emotions are screaming you to do so.

I can’t guarantee that steering clear of the euphoria that leads to aggressive investing at market peaks and avoiding the despair that causes you to be too conservative after the market falls apart will assure you’ll earn the highest returns or sidestep big losses. But by doing so, you’ll probably be less vulnerable heading into downturns, and better positioned to take advantage of the upswing when it occurs.


Filed under Uncategorized22 Comments Add a Comment

I just want to caution everyone that before jumping back into the market that everyone has their credit cards paid off. Too quickly we forget that one of the lessons out of all of this is that we cannot live beyond our means.
Posted By Matt Malinowski, Lethbridge AB: November 19, 2008 12:04 am

Why would anyone advise someone to invest in the stock market now. In 1929 there was a major down turn in the market. And in the end the stock market DOW dropped over 80%. We are in a worst crisis than in 1929. The dollar is about to slide over a cliff. And the tax base is being eroded away so the government won’t be able to pay the interest on our loans. Next year we won’t be able to have foreigners buy our bonds. Because the feel they would be too risky because of all our debt. The credit rating of the US will be downgraded. With all the spending we are looking at a hyperinflation senario similar to Wienmar Germany. The article is dreamland. Tell the kid to invest in silver/gold. In the depression you could buy a house for a couple of ounces of gold and in Wienmar germany you could buy a house for one quarter ounce of gold.
Posted By Kevin Rathdrum, Idaho: November 18, 2008 11:18 pm

Save at least 10% of everything you earn. Like Buffett says, be greedy when others are fearful and fearful when others are greedy. Learn and follow the Elliot Wave Theory. Read and learn about investing. Develop and strictly adhere to a long term investment plan. Learn and apply the dynamics and psychology of market swings and how they work and learn how to make them work for you. In essence, educate yourself and apply your knowledge on a long term basis.
Posted By Ramundo A, Lincoln, Nebraska: November 18, 2008 9:53 pm

I’ll tell you what, its been black friday for a few weeks now and I’m loading up on these bank stocks. In a few years it’l rebound and I believe what I put in it over the next year will at least double my value. at least. its on sale! citi for example is 75% off!
Posted By Anonymous: November 18, 2008 8:02 pm

Nice article. Sad to see all these people near retirement that had more than half of their stash in stocks and real estate. What’s even sadder is considering the moral hazard of the government now helping “too much.”
Stock Market has some interesting features, not widely advertised, like a real return since 1871 less than 2% on price appreciation alone (most people don’t believe this, but take the SP500 data since it started and calculate it yourself). On the other hand, including dividends, real return is 6.4%. Kind of like a bond, to support the argument of another writer to this post (but a bond with a heckuva a lot of volatility).
It also seems to have a 35 year oscillation in peaks and troughs, and the next trough is 2018. Hopefully past performance doesn’t predict future results!
Posted By Dave, Houston, TX: November 18, 2008 7:26 pm

I think what Walter is trying to say is :
Keep it simple to keep it manageable.
Meanwhile:
There has been a phrase bandied about in the press “too big to fail”.
I think that phrase needs to be changed to “too big for their britches” because “Wall Street” has been demanding “more liquidity” from the Federal Government for years.
I think that was a cover-up for “we gambled and made some bad bets so we need to borrow more money even cheaper so when we win a big one we can pay you back but meanwhile we need to pay ourselves several million dollars because we are such darn smart and clever people.”
So when you do your own investing, don’t get too big for your britches thinking you are smarter than “Wall Street” because they have more OPM than you do.
OPM being “Other People’s Money”
Posted By Jason Stoons, Austin TX: November 18, 2008 7:10 pm

One fundamental problem with our economy and Government is the unhealthly focus on the spenders–we bend over backwards to encourage people to go into debt, while at the same time practically eliminate all incentives to save our money (painfully low savings rates)–America’s problems will continue to worsen as long as we continue to spend beyond our means…and I’m talking about both Government and personal spending.
Posted By Nairb Sreoom, Biloxi, MS: November 18, 2008 5:21 pm

The current economics is really a paradigm shift to some basics, that will really develope into a new reality, a new way of looking at things. The promoters of sliced and diced investment “opportunities” have been found out. The repercussions of this failure are yet to be determined. Your article really tells us that it is back to basics, keep your investment strategy simple and understandable. I think the future will be the best time in our history, but only after a lot of lessons are learned and pain obsorbed. If the government bails us out too much, we won’t have learned anything.
Posted By Don Miner, San Francisco,: November 18, 2008 4:41 pm

It’s a shame that there is no TV show about simple, sensible investing principles: keeping costs low, tax efficiency high, diversification high, and allocation appropriate. Although they are the optimal strategy for nearly everyone, can you imagine watching a show that told you to do the same basic thing every week for years on end? LOL They could call it “Don’t just do something, stand there”!
Posted By John, Phila PA: November 18, 2008 3:56 pm

forgetting reality because you are chasing pie in the sky is a tough one. Any reference librarian can help you look up the long term advantage that large cap stocks have delivered over government bonds — it is only about 5%.
Every time you think you’re going to do significantly better than that 5% [before taxes, too] you have to know that you’re chasing pie in the sky.
Can it be done? sure — by experts. Then you have to ask yourself if you’re an expert. something like 99.95% of us are not.
If you’re not an expert, can you hire an expert? Absolutely — if you have millions to invest. However, for the average family, the expert needs to get paid so much that you can’t afford him or her. That means you’ll get average results. period.
Build your plan as if you’ll get average results. Then start becoming an expert and maybe you’ll be able to do better than your plan.
Posted By Spock_rhp, Miami, FL: November 18, 2008 3:10 pm

Good Points. On the whole we forgot about risk. We forgot that trees DO NOT grow forever into the sky. The signs were there for the Dot Com bust and not the housing/sub-prime bust. We forgot to look both ways before crossing the ’street’ and got blind-sided.
I’m 55 years old and have been investing since the early 1980’s and went through the crash of 1987, but this time I see with different eyes. All of my equities will remain fully invested, and will be left alone “to fend” for themselves…hopefully their value will rebound in the next 10 or 20 years. I was 80/20 stock to bonds…that’s now become 70/30 ratio. I plan to continue to save 21% of my income, but these monies are going into a GIC fixed instrument within my company 401(k). The other thing that I am doing differently, is to get back (sold my house in April 2008)into Real Estate, and make it a larger percent of my investments.
Good luck to all!
Posted By BIZ, Dunedin Florida USA: November 18, 2008 2:11 pm

All this advice is great if you have a pension to fall back on in hard times IN ADDITION to your 401K.If you don’t, you can’t save enough for a comfortatble retirement before turning 70 with all this brutal cycling.
Posted By Pat Savu Maplewood, MN: November 18, 2008 2:10 pm

The present meltdown has also shown us how unethical many of the financial corporations are. From the companies that rated AIG “AAA” to the derivatives that were “invented” for fast profits and big bonuses, we have learned that Wall Street lies, cheats and steals, without penalty.
Posted By kate, boston, MA: November 18, 2008 1:50 pm

The author is wrong about “much of the excess wrung out” - PE ratios are still excessive and there’s more downside to come.
Posted By Jack Thomas, Tucson, AZ: November 18, 2008 12:55 pm

It is well written , it truly is the fact , putting the bad to the past ,thought the worst could not be over yet , you could expect another 20 % lower values in the stock market ,look out for the DOWJONES to come to level of 7000 to 7400 to enter the market and stay in the stock of atleast 6 months .to get real returns , if one can stay invested longer , better returns are expected .the market will come back to its original level in 3 years , there could not be a better time to get in to the market if one has the cash liquidity ,
Posted By mansoor ,moradabad ,india: November 18, 2008 12:30 pm

Excellent article
Posted By Anonymous: November 18, 2008 12:29 pm

Great aticle , the only way i can recover capital losses is by jumping back in and yousing my capital gains as tax write offs , it will take some time im not going to miss the rebound ive lost to much .
Posted By Bernie Blyth , Australia: November 18, 2008 12:28 pm

I think these are all good and positive ideas, but if we continue to think that the stock market will again go upwards like it did in the dot com peak and the housing market boom, we may be in for a surprise. With all of these bailouts and the companies not doing what they are supposed to do with taxpayer’s money, big business has learned nothing from this. All they will do is blow it and then turn to the government for help…AGAIN.
Posted By Lee, Shreveport, La: November 18, 2008 11:18 am

My advisor told me,rich,is when you marry it, inherit it or compound interest. Re invest the dividends back into the stocks. I believe him, and that is what I am doing, but only good stocks,like GE,Bristol Myers, and yes Visa is a great buy right now. As long as you have a cash reserve,buying into the good stocks, remember, the stock market has thrown out the “baby” with the wash. Take advantage of the blue chips.
Posted By Ken Wayne, Boca Raton,Fl: November 18, 2008 11:17 am

I agree with article - thanks
Posted By Terrace, Gulf Breeze, FL: November 18, 2008 10:22 am

all these principles are fine to write about but not practical given the current scenario. there can be only one Warren Buffet and one Bill Gates. while your house is burning you cant read or remember fire prevention rules or bye laws you have to act.Moreover today’s situation is s spill over of years of faulty financial expansionary policies & it will take a long time to reassert fundamentals which are neither so distorted nor flimsy
Posted By Aj missassauga ont.: November 18, 2008 10:09 am

Excellent article. Let’s remember that fear builds on fear and that is exactly what we’re seeing on today’s market. The smart investor today will analyze current fear trends and gradually inject back into the market when the underlying causes for concern have been dealt with.
There is always inherent risk in investment, but personally I’m excited about the opportunities that this is bringing. Also, I hope that a new generation of investors will be more atuned to the risks involved with investment and will be more ethically inclined in the future.
Posted By Mitesh Vashee, Dallas TX.: November 18, 2008 10:00 am
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