âNever let a good crisis go to wasteâ â Winston Churchill
Dear Fellow Fools,
Itâs been five years since the bankruptcy of U.S. investment bank Lehman Brothers left the financial world on a precipice. Thanks to unprecedented government intervention, some degree of footing was maintained — but the Lehman bankruptcy and ensuing financial crisis continues to be a favourite talking point for the media and the pundits of the world.
We investors can read all the books, take all the courses, and get as many letters behind our names as we want. But investing is a lot like life — the most important aspects are often learned by doing. There are few substitutes in this industry for practical experience.
And in my mind, no textbook will ever be convincing enough to substitute for what I learned as an investor during the financial crisis that Lehmanâs bankruptcy spurred. In this weekâs Take Stock, Iâd like to share the three most significant lessons the financial crisis taught me.
Lesson 1: Cash is king
In my personal portfolios, I went into the financial crisis fully invested. Itâs something I regret to this day. I had no liquidity — which left me unable to act through the teeth of the crisis.
The textbooks and know-it-all strategists say that if you see a better opportunity out there, sell what you have and move into it. To that, I say ⊠easier said than done. Try loving a companyâs prospects one day and then seeing its stock trade down by 50% two weeks later for nothing that is company-related. Youâre simply not going to sell that stock — even if the best opportunity in the world comes along. Our brains wonât let us. Itâs too painful to realize that loss.
Itâs far less of a psychological hurdle to always have access to cash in your portfolio, even if itâs just a bit, and put it to work when a fire-sale comes along. The argument against cash is that is earns you nothing. This is true in the short term if you think of cash as simply an absolute holding. Instead of thinking of cash as dead money, think of it as a portfolio management-related tool that allows you to pounce on a golden opportunity whenever it comes along. In that context, cash can in fact earn you a great deal!
Cash is anything but dead money if itâs put to the proper use.
Lesson 2: Leverage kills
This one is two-pronged. Although I was fully invested, I was very happy to not have been using margin and investing beyond my means. Utilizing margin to purchase stocks can do wonders to your returns on the way up. But it can be an outright disaster on the way down.
You see, on the way down, two of an investorâs least favourite words tend to come into play: âmargin callâ. A margin call from your broker can force your hand into selling a position at what potentially could be the very worst time. At least if youâve invested without leverage, you can ride through the downturn and not be forced into taking a capital loss.
The other angle is on the company side. Simply, companies that are reliant on free and easy access to the debt market donât do well in financial meltdowns. When youâre looking at a company, take its financial position very seriously. Financial risk can kill a company under the wrong conditions and this, like a margin call, can lead to the permanent impairment of your capital.
Lesson 3: Markets always come back
While the scale of the 2008-2009 financial crisis may have been unprecedented, market meltdowns have occurred before, and will again. Show me a market meltdown, though, and Iâll show you a market comeback. Over the long term, the stock market simply canât be held down.
To be clear, itâs not that the market doesnât go down. It does, and it can stay depressed for long periods of time. However, once the clouds part, the returns can be spectacular.
The chart below utilizes Professor Robert Shillerâs data to demonstrate 10-year market returns in the U.S. since 1871 (far more historical market data is available in the U.S. than in Canada). The average return over these 10-year periods was +38.1%. The best 10-year period produced a +222.5% return (1989-1999) and the worst resulted in a loss of 62.7% (1911-1921). Of the 133 periods included, 44 (or 33%) were negative.
Source: Robert Shiller
This data can be framed in a bunch of different ways, but the primary message is this: Over the long term, the market goes up a lot more frequently than it goes down. And remaining invested over the long term is the best way to ensure you come out with a positive return when all is said and done.
While it would have been nice to have cash on hand, the fact that I wasnât forced to sell anything during the crisis, and didnât need the money I had tied up, allowed me to benefit from this powerful long-term trend.
The Foolish bottom line
One of the great things about the world of investing is that hardly a day goes by that doesnât offer a chance to learn something new. Whether it be about the market, a company, or ourselves, investing is a game of constant evolution.
The financial crisis that began five years ago packed an undergrad, post-grad, and doctorate degree worth of learning into about a two-year period. It was life-altering in many ways, one of which was the lessons that it taught. These three takeaways from the financial crisis of 2008-2009 will stick with me for the remainder of my investing life.
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