As a society we place a high priority from learning from our mistakes. Even relatively small-scale disasters are followed up by thorough investigations to determine what caused them. For example, the National Transportation Safety Board investigates every single accident involving a U.S. aircraft.1
One of the costliest disasters in recent history was the market crash of 2008. From its peak to the lowest point, The Dow Jones Industrial Average index lost a third of its value. The federal government responded by pumping hundreds of billions of dollars into a financial bailout plan designed to stave off a potential depression.2
In the years that followed, government officials, academics, and Wall Street experts have studied this financial crisis from every angle in an effort to understand why it happened, and to figure out ways to keep it from repeating.
While the basic facts about what caused the investment banks and insurance companies to start failing are not hard to ascertain (short answer: mortgage backed securities), what’s more difficult is to determine why people who should have known better enabled the disaster to unfold.
Though the public wants answers right away, something as complex as the collapse of entire financial system requires more time to reflect back and identify the primary causes.
About a year ago, near the 10th anniversary of the 2008 crash, University of Pennsylvania’s Wharton School of Business convened a conference in New York titled “Financial Markets, Volatility, and Crises: A Decade Later.”3
As you can imagine, the panelists were not in agreement on everything related to the crisis. For example, they had a divergence of opinions on exactly when it started. But they did tend to agree on some of the primary human factors involved.
Bruce Jacobs, co-founder of Jacobs Levy Equity Management, said that the crashes of 1987 and 2008 were both fueled by “free lunch strategies.” He said that investors had an expectation of protection and safety, and at the same time the securities were sold to them on the basis of higher returns.
In other words, contrary to what global markets have evidenced for decades, people once again thought they could earn huge gains with virtually no risk.
Richard Lindsey, co-head of liquid alternatives at Windham Capital Management, said that crises often begin when a new product or approach is sold as a panacea to the risk/return trade-off. When neither the firms selling it or the investors buying it really understand the product, accurate risk assessment is almost impossible.
Vineer Bhansali, founder of LongTail Alpha investment advisory services and survivor of five financial crises, agreed. He said that the catalyst tends to be “a great theorem that goes bad because it’s abused and levered up.”
Unfortunately, Bhansali observed, investors tend to have a short memory. Once the crisis is over, confidence returns, and investors start chasing returns again.
The prudent investor should learn two things from this.
First, greater returns should always be expected to carry greater risk—there’s no such thing as a free lunch.
Second, significant market volatility, including full blown financial crises, should not come as a surprise. In fact, you should prepare for them both emotionally and in your long-term investing strategy.
Maintaining a healthy emotional outlook and a prudently-diversified strategy are fundamental to helping you endure the unknown future as an investor in global markets. Your trusted advisor can help ensure that you maintain a proper perspective on your journey toward your ideal financial outcomes.
Citations:
1 – https://www.ntsb.gov/investigations/Aviation/Pages/default.aspx
2 – https://www.britannica.com/topic/Financial-Crisis-of-2008-The-1484264
3 – http://knowledge.wharton.upenn.edu/article/causes-financial-crises/