The sufferings of investors during the period should be a reminder to the present day investing community on the risks in the capital market.
It’s a decade since the news of the collapse of the iconic Lehman Brothers on September 15, 2008, rocked the world triggering off the Global Financial Crisis that ravaged financial markets for the next several months.
While institutions across the world got caught in the mess and many collapsed, the resultant meltdown of stock markets around the globe led to massive erosion of investor wealth, leading many to penury.
There is no certainty that a similar event, even if it not linked to real estate sub-prime lending that triggered off the meltdown in US and spread like a virus around the globe, will never happen again. The sufferings of investors during the period should be a reminder to present investors on the risks in the capital market.
So what are the lessons learnt during 2008 after that investors should never forget and which are relevant event today? There are many including the risks of over-borrowing, investing with borrowed money and concentration of investments in a single asset class.
Here we look at some of the larger things that the investing community learnt the hard way in 2008 and which present day investors should be mindful of:
Extreme leverage is extremely risky
At the bottom of the 2008 crisis was the extreme borrowing (leverage) by governments, corporates and individuals to maximize returns. Borrowers across the spectrum were taking loans to maximise returns ignoring repayment capacity. This led to huge defaults when the tide went against them.
“Everyone borrowed more than they could possibly payoff and when the interest rates went up the loans were not able to get rolled over and hence lead to large-scale defaults. Indiscriminate lending was another aspect that exacerbated the 2008 crisis; esoteric financial products such as Mortgage-backed securities were created which were nothing more than bundles of toxic loans and where then sold off to unsuspecting individuals with a promise of better returns. An important lesson for individuals perhaps should be to stay away from fancy investment products about which they do not have adequate knowledge,” says Rahul Agarwal, Director, Wealth Discovery/EZ Wealth.
Rahul Parikh, CEO, Bajaj Capital says leverage is a double edged sword since it tends to benefit when times are good, but, kills when the tide turns. “This is precisely what happened in 2008 when asset prices turned. The excessive leverage accumulated at banks, corporates and households simply made matters worse and caused panic, freezing money markets and bringing the financial system to a standstill,” he said.
Never invest borrowed money
Parikh points out that in the lending frenzy preceding 2008, money was lent to borrowers with a weak credit profile. The sub-prime loans were then bundled with a pinch of good quality loans and sold off as high grade structures / securities. People started believing in “risk less returns” or “high returns at lower risk”. As they found out later, risk was lower only in their imagination. What collapsed the house of cards was just a few of those weaker hands to default. “So the takeaway for investors what while leverage has to be kept in check, borrowed money should never be used to invest. Higher returns carry higher risk. You may not be able to see the risk, but it is there nevertheless. The corollary however is not always true i.e. higher risk may not necessarily carry higher returns,” Parikh says.
Do not cash out during crisis; Buy, if possible
The global stock market meltdown was also caused by panic selling by investors as news of the contagion spread. This resulted in many stocks been beaten down to unprecedented low levels. If you were a smart investor with money in hand, you should have been buying to make gains in the long run. Markets have a tendency to bounce back from such lows. “Markets are back at historic highs both Nasdaq and Dow continue to scale new highs and even in the Indian context both Sensex and Nifty are close to their life time highs even after the corrections of the last couple of weeks. An important lesson for individual investors is to not cash out or book their losses when the markets are in a downward spiral; meltdowns are opportunities to accumulate good quality stocks with a long-term perspective. Someone who had cashed out at that point would never recoup their losses as their exit time was at the lowest point on the same hand people who ventured out and averaged down at that point not only did make up for their losses but also are sitting on handsome gains,” says Rahul Agarwal.
Anil Rego, Founder and CEO, Right Horizons, agrees. “At the peak of the crisis, many domestic investors withdrew from the markets fearing the worst. This type of fear psychosis led to many investors booking permanent losses. However, those investors who braved the volatility have pocketed great gains. That is as real as a lesson can be,” he said.
Always maintain sufficient liquidity
While one should try and remain invested for long term even if markets are volatile, one should always have liquidity to enable buying when markets are on a downward spiral. “One can only average down if they maintain sufficient liquidity in their portfolios at all times for situations like these. This emphasises the importance of taking some money off the table and to never be fully invested,” says Agarwal.
Have a diversified portfolio
The crisis of 2008 highlights the importance of a broad and flexible investment approach. To withstand financial turmoil it is essential to have a diversified portfolio of assets across the spectrum. “One can minimise the pain, though one must understand that one will have to sacrifice some returns to do this. Diversification is one such way. Diversification can be done across asset classes, securities, investment styles and geographies. Diversification essentially means investing in a mix of assets that have a low or negative correlation between them. It has been seen that Cash and precious metals such as Gold,” says Rahul Parikh.
Agarwal also bats for a diversified portfolio to minimise risks. “Good investment opportunities are always around and are dispersed across various sectors and markets, investors should therefore learn to be flexible in their choice of investment options and should always opt for a diversified portfolio,” he said.
Stick to known assetsHowever, financial advisors says even while diversifying one should try not to get into asset classes they do not understand. The global financial crisis was triggered off by lenders selling products like mortgage-backed securities which many investors did not understand but took positions in. “Stick to what you know and what you understand. The filing for Chapter 11 bankruptcy protection by Lehman Brothers was only because the bank had become deeply involved in mortgage origination. In the end, it had effectively become a real estate hedge fund disguised as an investment bank. Since it was exposed to real estate and not lending, at the height of the subprime mortgage crisis, it was vulnerable to any downturn in real estate values. Often, investors also stop being themselves. In the name of diversification, they get into assets they actually do not understand. That is the start of trouble,” says Anil Rego.