Are you ready for the next financial crisis?

This month marks the 5th anniversary of the 2008 financial crisis and the panic selling that gripped the world in the wake of the bankruptcy of Lehman Brothers. The dangerous phrase, “This time is different,” was uttered continuously suggesting that the markets would dive further and stay down for years.

Since the markets have never behaved that way, we doubted things would unfold that way. The media was full of stories about how people should react and was dominated by a short term viewpoint we felt compelled to reject. Five years later, the markets have long ago recovered and are now near all-time highs. Eventually, there may be another bad market, but if you follow the guidelines outlined below, you have an excellent chance at a successful investment experience.

Following the news closely is more likely to hurt than help. The last twenty years presented one of the strongest market rises on record followed by two of the largest stock market drops, the worst recession since the Great Depression, and another exceptional market recovery. If ever there was a period where maneuvering in and out of markets based on news could have added value, this was it. Yet the record is clear: almost no one bested the market after taxes by any notable margin. Most fell short, many by a wide margin.

Prudent investing is a long term endeavor but the media is fueled by the short term. Today’s media exists to sell ads. It is provocative, controversial, and even sensationalistic in order to make sure you keep coming back for more. The news can make one anxious, fearful in bad markets, greedy in good markets, and focus on things that seem urgent but are often irrelevant. In short, the media is the enemy of patience and discipline, two vital criteria for investment success.

Financial planning is critical to making sound financial decisions. The best decisions are made with relevant information, proper perspective, and with emotions kept in check. A good process methodically and objectively assesses the situation and demands evidence, not good stories or sales pitches. It also provides a framework for making the right adjustments at the right time.

Sound financial planning intelligently chooses what types of risk and how much of these risks make sense for a given family. It expects markets to be volatile and incorporates a process for adjusting to the fluctuations that always come. Good planning helps families see the probable consequences of their actions before they make decisions, fostering helpful actions while minimizing preventable and costly mistakes.

During the financial crisis, planning helped us avoid the panicked responses that afflicted so many people who were caught up in the emotion of the day. It helped us get through the many subsequent news events falsely labeled “crisis.” Planning helped us make decisions about tax loss harvesting, Roth conversions, mortgage refinancing, adjusting withdrawals, and portfolio rebalancing – all actions that proved wise.

Rebalancing requires neither insight nor good timing to be effective. How do you make money in the markets? Buy low, sell high. Duh! Simple to say but hard to do, particularly when the market is moving dramatically and the news is awful. The S&P 500 index’s return from 9/30/08 (the month end closest to the collapse of Lehman Brothers) to 9/30/09 was -6.91%. However, many portfolios that rebalanced during the ‘08-‘09 market swoon had smaller losses, if any at all. This result is a function of the mathematics of rebalancing and is not dependent on picking the bottom of the market. It resulted regardless of whether the rebalancing occurred prior to or after the bottom.

Rebalancing forces us to trim parts of the portfolio that have done well (after we have been rewarded for taking on the risk) and buy more of the parts that have lagged. Broadly diversified holdings of meaningful assets have always recovered eventually. Over time, rebalancing usually adds to our returns.

More important than enhancing returns, employing a rebalancing methodology helps manage risk. Rebalancing only involves a portion of a portfolio and keeps people from chasing what is hot while offering a way to exercise discipline.

Stocks offer the best odds long term. Stocks have made and should make money in excess of inflation over the long term because in a capitalist economy, corporations are free to make whatever changes they believe are needed to make a profit. When you own stocks, you are an owner of those businesses.

No matter what the economic, tax, or political environment, corporations are looking to make money and the ones that succeed are worth more. This is why the market has always recovered. By owning broadly diversified holdings of stocks, you can enjoy this increase in value without having to bet on which corporations will be winners and which will lose.

Diversification reduces risk. In addition to the type of diversification we just described, diversifying among asset classes reduces risk. During the crisis time, many stories appeared claiming diversification did not work because stocks of all kinds around the world dropped in value. The stories largely ignored the fact that broad based sell-offs happened often in prior times of turmoil too. It also ignored the tendency for different asset classes to recover at differing paces. Holding a variety of foreign securities, for instance, did not minimize losses during the crisis but did aid the recovery as the panic subsided. The MSCI Emerging Markets Index increased a spectacular 79% in 2009.

The crisis also showed us the tremendous value of always holding some good quality short to intermediate bonds in a portfolio. When the market dropped, these bonds held their value admirably. Losing less meant recovering more quickly. Bonds represented a good source of funds from which to buy stocks in the rebalancing process, also speeding portfolio recovery.

“Buy and hold” is alive and well. During the crisis, there was a chorus of people claiming buy and hold was dead. “Don’t just sit there, do something,” we were told. This line of thinking is encouraged by people who want the public to adopt incorrect definitions of “buy and hold.” Buy and hold never means the market cannot go down. In fact, it assumes the market will be volatile and therefore the best chance of profiting is to stay invested for the long term.

A correct definition also never means buy and ignore. Low stock prices offer many opportunities, several of which we have already mentioned. From what we can tell, the primary motivation for stating “buy and hold is dead” is to prey upon people’s fears and convince them to employ the services of the trader, hedger, market timer, or “alternative” investment provider.

It may sound sensible on the surface, but dig deeper and the record is clear. Most traders, hedgers, timers, and alternative product purveyors failed to add value – and some failed spectacularly. Once again, it has been shown that patience is a critical component of a successful investment experience and that resilience is far more important than nimbleness.

Wall Street and other brokerage firms exist to sell you stuff, not to help you. Perhaps the greatest irony in all this is that the people who have been touting their nimbleness, market or economic insights, hedging strategies, and alternative investments are the very people who caused the crisis in the first place – Wall Street! These firms created lousy products and dumped them on their customers. They did a horrible job of managing risk as they bet against the very securities they sold, and then offered themselves as a guiding hand through the turmoil.

The next true crisis will look different than past ones because each crisis has in fact, looked different. What has not changed is the effectiveness of the guidelines we just outlined. The guidelines resulted from lessons learned quite clearly through each of those prior periods. Investors who learned those lessons and adopted the above guidelines made sound decisions when the next crisis came. Learn these guidelines and make them a part of your financial philosophy and you have an excellent chance of a successful investment experience.

If you have any questions or would like to discuss this further, please give us a call or send us a note.

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