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Three investment lessons learned from the global financial crisis

Ten years on from the global financial crisis is a good opportunity for investors to reflect on what we’ve learned from this seismic event.

Lesson 1: Minsky was right

Hyman Minsky’s financial-instability hypothesis examined how long stretches of prosperity have tended to sow the seeds of the next crisis.

In good times, market participants become inattentive to assessing, quantifying, and managing risk, says Minsky. The discipline of risk management wastes away; risks are underestimated and under-hedged. Imbalances and vulnerabilities gradually build up within the system, which eventually culminates in a crisis.

Lesson 2: Active and independent central banks are important

When the global financial crisis hit, we may consider ourselves fortunate that it was a student of the mistakes of the Great Depression who was sitting in the world’s hottest seat. Federal Reserve chairman Ben Bernanke and his colleagues at the US central bank deserve considerable credit for the role they played in averting a depression.

The policy mistakes which played a role in the economic and social horrors of the 1930s were not repeated. Aside from aggressively slashing interest rates, the Fed famously undertook the unconventional monetary policy of quantitative easing in order to lower long-term rates.

Importantly, central banks also took a much more active approach in regulating the financial sector. Higher capital requirements, multi-agency stress tests on systemically important banks, and prohibitions on proprietary trading are some of the regulatory changes which followed the crisis. As a result, the financial system’s most systemically important institutions are more resilient to sudden shocks compared to the past decade. The crisis reinforced the incredible importance of a competent central bank with the ability to deliver the right dose of monetary medicine and the scope to play party pooper if needs be to avert future financial crashes.

Lesson 3: Take a long-term view

Even if you had been unfortunate enough to invest in the Standard & Poor’s 500 (a stock market index which contains 500 of the largest stocks in the US) at the index’s highest level – and ahead of the crisis in the last three months of 2007, you would still have doubled your invested capital by today. Of course, if you had skipped the crisis and invested right at the bottom in 2009, you would have multiplied your investment five times.

However, in spite of the golf course boasts to the contrary, there were few such investors.

Ironically, it was the severity of the crisis which set the stage for the market’s dramatic rebound. The crisis led to massive write-downs of financial assets at banks, insurers and some large manufacturers with substantial financing departments, resulting in the largest proportionate fall in corporate earnings on record.

However, when the write-downs stopped, some very large negative items disappeared from profit and loss statements, resulting in a proportionally faster rise in corporate profits.

Today, US corporate profits are now 15 times higher than the low point reached in 2009, as companies have benefited from a world economy which has consistently confounded its many detractors. The performance of the US stock market 10 years on from the crisis is a testament to the virtues of taking a long-term view of investing as the longer your time horizon, the higher the investment odds are stacked in your favour.

Article Source: http://tinyurl.com/kbwqb42

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