Showing posts with label anatomy of a crisis. Show all posts
Showing posts with label anatomy of a crisis. Show all posts

Saturday 23 June 2012

This is the opportunity facing you today. You could be at the forefront of the largest gains when the tide turns.


Sure, there may be volatility in the market for some months ahead. Years even. But this should NOT stop you from taking control of your financial destiny.
Your money might survive being mothballed in a bank account, gathering a feeble 1% or 2% per year. But unless you can get a pay rise or a windfall sometime soon, nobody is going to help you grow your wealth in the many alternatives available.
At some point, the markets will rise again, and – in our view – those who are already invested in rock-solid shares should make serious gains.
I'm old enough to remember all sorts of stock market crashes and periods of underperformance -- the causes and durations of which are long since lost in the mists of time.
What I do know is that markets eventually recover, and carry on heading upwards – carrying our stocks, and investment wealth, with them.
This is the opportunity facing you today.

You could be at the forefront of the largest gains
when the tide turns

The majority of private investors are too scared by what happened in the last few years to invest right now.
But looking backwards and doing nothing is not the way to take control of your financial destiny.
Think of it this way. You'd be crazy to drive your car whilst spending all of your time looking in the rear-view mirror.
And yet many people invest like this. They assume that because 2011 was a tough year for the world's stock markets, 2012 will be just as bad.
But the financial world doesn't work that way, especially the stock market. The past is... well... history.
The tide turns when everyone least expects it. The more obvious the market's direction seems, the greater the odds that you're wrong.
As Floyd Norris of The New York Times has pointed out that, for the past half-century, the market has moved in 15-year cycles where returns swing from spectacular to near-zero.

In 1964, the average real return over the preceding 15 years was a stellar 15.6% a year.
Then it flipped. By 1979, the previous 15 years produced a negative real return.
Then it flipped again.
By the late 1990s, 15-year average returns were near record highs. And again – as of the end of last year, stocks returned a measly 3% a year over the last 15 years.
The trend is clear: After booms come busts, and after busts come booms.
Sound crazy? It sounded crazy in the early 1980s, too.
So did the notion 10 years ago that we were about to face a decade of stagnation.
That's always how these things work. After booms come busts, and after busts come booms. Happens over and over.
Of course, history isn't guaranteed to repeat itself. And what drives stocks to a decade of low or high returns isn't the calendar: it's valuations. Stocks do well after they're cheap, and poorly after they're expensive. So the real question shouldn't be how long stocks have been stagnant, but whether they're cheap.
And right now we believe they are.

Saturday 14 March 2009

Preventing the Next Crisis

Preventing the Next Crisis
by Jack M. Guttentag
Posted on Wednesday, March 11, 2009, 12:00AM

While policymakers and their kibitzers, among which I count myself, debate what is needed to cure the current crisis and associated recession, another debate brews in the background: how to fix the system so that it doesn't happen again.

Any coherent proposal for fixing the system is necessarily based on judgments about the causes of the current crisis. While there are many differences in emphasis, I believe that most observers would agree on the essentials: the crisis originated with a bubble in the residential real estate market, followed by its inevitable aftermath of declining home prices, and a subsequent explosion of home mortgage defaults and foreclosures.

The resulting losses were worldwide because foreign investors held enormous amounts of U.S. mortgage-related assets. Global financial institutions did not have the capital to absorb these losses, resulting in the collapse of many, and enormous infusions of capital by governments, plus loans and guarantees, to prevent the collapse of many more.

Shoring Up the Financial Systems

This sequence of events could be prevented by blocking the bubble, or by shoring up the capacity of the financial system to absorb the losses resulting from a bubble's collapse. In my opinion, the second should have priority. We don't know where the next bubble will come from, but if the system has enough capital, a crisis can be averted regardless of its source.

Private financial institutions will never voluntarily carry enough capital to cover the losses that would occur under a disaster scenario. For one thing, such disasters occur very infrequently, and as the period since the last occurrence gets longer, the natural tendency is to disregard it -- to treat it as having a zero probability. In a study of international banking crises, Richard Herring and I called this "disaster myopia."

Disaster myopia is reinforced by "herding." Any one firm that elects to play it safe will be less profitable than its peers, making its shareholders unhappy and even opening itself to a possible takeover.

Playing It Safe Not the Best Option

Furthermore, even if those controlling financial firms knew the probability of a severe shock, and the very large losses that would result from it, it is not in their interest to hold the capital needed to meet those losses. Because they don't know when the shock will occur, playing it safe would mean reduced earnings for the firm and reduced personal income for them for what could be a very long period. Better to realize the higher income for as long as possible, because if they stay within the law, it won't be taken away from them when the firm becomes insolvent.

Indeed, insolvency may not mean the demise of the firm if many firms are affected at the same time. The government can't allow them all to fail without allowing the crisis to become a catastrophe. This is clearly borne out by the government's actions in the current crisis. Government bailouts further validate the premise that it is foolhardy for a financial firm to hold the capital needed to meet the losses associated with a very severe shock.

This appears to lead logically to the conclusion that the government ought to impose capital requirements on financial firms. Capital requirements stipulate the amount of capital firms must have, based largely on the amounts and types of assets and liabilities they have.

Capital Requirements: An Inherent Flaw

Unfortunately, capital requirements won't prevent financial crises. An inherent flaw in capital requirements is that required capital varies by broad asset categories, which allows the regulated firms to replace less risky assets with more risky assets within any given asset class. The shift to subprime mortgages during the last bubble, for example, did not increase their required capital.

In principle, regulators can offset this by making discretionary adjustments in the requirements in response to changing economic conditions. For this to work, however, regulators must have better foresight than those they regulate, which they don't. Neither should we expect regulators to have the political courage to "remove the punchbowl from the party."

An increase in capital requirements large enough to burst a bubble would be extremely disruptive, forcing many firms to sell stock at the same time, and/or to substantially reduce their lending. Concerns about such disruptions reinforce disaster myopia and political timidity among regulators.

The proof is in the pudding. Banks and other depositories have been subject to capital requirements since the 1980s, but no adjustments in the requirements were made in response to the recent housing bubble.

http://finance.yahoo.com/expert/article/mortgage/147279

Wednesday 29 October 2008

Anatomy of a Crisis

The urge to panic in the wake of a crisis is understandable and this is one of the greatest fears that many investors face.

One of the best ways to confront our fears is to understand them.

(Basically, we are faced with the following fears: Fear of failure, fear of loss and fear of the unknown.)

In this section, we look at what generally happens in a crisis and some of the questions you should ask when a crisis hits. We will also look back in history and feature some events to draw out important lessons for the future. From this, you can figure out what actions are more likely to be productive and what actions are more likely to be counter-productive.

When a crisis hits

Take 9-11, for example. Now, imagine that it is the day after the destruction of the Twin Towers. Profound shock waves will be felt in New York and beyond, and this will send ripples through to the world economy for some time.

On the morning after, it is near impossible to know exactly how events will play out over the next few weeks or months. But there is a set pattern to how financial markets react to a crisis, historically, and there are a few things worth noting.

Firstly, the inital reaction will be shock. Financial markets hate uncertainty, and nothing creates more uncertainty than a sudden, shattering crisis. The result of the shock is typically a "flight of safety", as investors dump stocks in favour of bonds and cash. Stock prices will, therefore, almost always fall.

At this point, the greatest danger to investors is not shock or that prices are falling, but the urge to panic. When investors panic, they sell at low prices and end up buying back the same stocks later at much higher prices. This knee-jerk effect comes at a high cost for investors, who buy high and sell low.

The second reaction, which usually happens immediately, is increased volatility in the commodity markets. Will the terrorists bomb oilfields and stem supply? Will grain shipments be interrupted? Will demand for gold rise sharply? Uncertainties that affect basic commodities usually cause spasms in the markets.

A third reaction is over-compensation. The first shock wave of selling is often broad and steep. Then, when uncertainty dissipates, investors usually overreact in the opposite direction, sending prices back up to pre-crisis levels.

Things never seem the way they are during a crisis. What you should remember is that the impact of a crisis itself is typically a short-term matter. After a few weeks, calm usually returns. This is not to say that crises are inconsequential or insignificant. The tsunami disascter (26 December 2004) which caused tremendous destruction in Indonesia will require billions of dollars and many years of restoration work. Certain markets may stay depressed for longer.

Historically, what effect a crisis has on the financial markets depends on whether the crisis creates a long-term change in the fundamental nature of an economy. And in most cases (even in the case of the tsunami disaster), the fundamental structures of the affected were not subjected to drastic modifications.

To sum up, the typical pattern following a major crisis is this:
  • first, there will be a wave of panic selling when the news breaks.
  • Then, there will be a short period of instability,
  • followed by an upward sweep once investors realise the crisis itself is not likely to have a long-term effect on the economy.

So, should you find yourself in the midst of a crisis in the future, remember:
  • Do not engage in panic selling.
  • Sit tight and stick to your strategy.
  • If you are a long-term, buy-and-hold investor, do hold on.
  • If you are an adventurous investor, follow your strategy to buy on dips.

Make sure your overall portfolio is designed to limit your potential losses during a substantial market decline. This is where you need to invest in many different things.

Ref: Make your Money work for you, by Keon Chee & Ben Fok