“When you combine ignorance and leverage, you get some pretty interesting results.” - Warren Buffett
As the 10th anniversary of the 2008 Financial Crisis approaches, it’s a good time for investors to look back at the most significant economic shock since the Great Depression and consider what has been learned.
Going into 2008, few predicted that the global financial system was heading toward an apocalyptic meltdown. Excessive use of leverage by both individuals and institutions, which was driven by lax mortgage underwriting and the proliferation of exotic derivatives, created an unsustainable bubble in U.S. home prices.
The ensuing collapse of the financial system took a severe toll on the U.S. economy – 9 million jobs were lost and 8 million homes went into foreclosure. Many stock portfolios were cut in half and home values across the country fell by about 40 percent on average.
Quantitative easing and bank bailouts ultimately averted a repeat of the Great Depression, but the Great Recession that followed was the most severe economic downturn in two generations. While the U.S. economy as a whole is now on solid footing, there are many individuals and investment portfolios that have yet to fully recover from the damage inflicted by the Financial Crisis.
What We Learned
While the Financial Crisis was devastating to economies worldwide, valuable lessons and patterns emerged from the wreckage that are now clear in retrospect.
Correlations rise during times of turmoil. Asset classes like stocks and residential real estate, which don’t normally move together, can become highly correlated during a crisis.
Leverage amplifies risk. Excessive leverage puts investors at the mercy of credit markets during a crisis.
Asset class returns will revert to the mean. Returns for different asset classes can deviate wildly from historical averages for periods of time, but ultimately, they will revert to the mean.
Recency bias can be hazardous to your wealth. The human mind has a natural tendency to expect more of what has recently occurred. When this leads investors to sell near the bottom and stay out of the market, it can damage investment portfolios irrevocably.
Prudent planning and the fortitude to stick with a long term strategy go hand in hand. While sticking with an investment strategy during a dramatic market decline isn’t easy, a financial plan helps investors maintain a long-term orientation during times of turmoil.
Where We Are 10 Years Later
The lessons learned from the 2008 Financial Crisis have placed us on a more stable path toward economic growth. For example:
Lending standards have tightened, leverage has declined, and household savings rates have increased. Mortgages are no longer available without proof of income, and leverage at banks has declined significantly. Savings rates have increased, and Americans are less inclined to tap home equity after the crisis. Tightened standards and regulations should help to prevent another bubble like the one that preceded the Financial Crisis.
The job market has recovered, stocks have rallied to new highs, and home prices have rebounded. After years of lackluster job growth, the unemployment rate in the U.S. has fallen to a 30-year low. Stock prices have quadrupled from financial crisis lows, and home prices have rebounded, although they remain below the pre-crisis peak in many parts of the U.S.
Despite the strength of the current recovery, we still face challenges that have the potential to destabilize the economy if they continue to remain unaddressed. For example:
Bank bailouts helped avoid a worst case scenario, but “Too Big to Fail” remains an issue. As the large U.S. banks have continued increasing their market share, their failure today would threaten the broad economy as it did during the Financial Crisis. Many critics wonder if institutions should be allowed to grow to the point that that their failure threatens the economy at large.
Asymmetrical incentives that drive executive compensation remain problematic. The skewed incentives that drove Wall St. executives to take too much risk haven’t been adequately addressed.
What That Means for Us Moving Forward
“We always live in an uncertain world. What is certain is that the United States will go forward over time.” - Warren Buffet
Savvy investors should take the lessons learned from the past 10 years to heart — as dire as a crisis may seem, a properly managed portfolio will reward diligent and steadfast investors with healthy returns over long periods of time.
Stay long and don’t try to time the market. U.S. stock indexes always recover from losses over time, and research shows that attempts to sidestep market declines are counterproductive.
Expect the unexpected. Investors who expect low probability events to occasionally occur will be less likely to react emotionally to surprises.
There’s no substitute for diligent planning; consider the value of professional advice. Failing to plan is indeed planning to fail. An investor without a financial plan is more susceptible to emotion-driven financial decisions. If you need help constructing a financial plan to guide you through the highs and lows of the markets, consider the value of a CFP® professional’s expertise and experience.