Ten years ago the economy unraveled, the stock market plunged 52%, and the financial system was on the brink of no longer functioning. Some of our biggest financial institutions either failed or needed a massive capital infusion from the U.S. Government to stay solvent. Headlines were dour; people were losing their jobs, their homes, and their retirement savings.
In the years since, we’ve recovered fully from these uncertain, chaotic times and have righted the U.S. economy. We now stand as the strongest, wealthiest economy in the world, with unemployment at all-time lows, household net worth at all-time highs, and a stock market that is making new highs regularly. The excesses and turbulence that led to financial panic have dissipated and now it’s time to reflect on the lessons that we’ve learned.
Lesson Number One: Fear is the enemy.
Time and again, we have seen that fear is the cause of the greatest mistakes made by investors. Fear of missing out on that hot stock, fear that your neighbor is making more money from his portfolio, fear that you are being left behind as the speculators and house flippers earn outsized sums from little effort, fear that losses will be permanent, fear that prices will go lower.
Fear and greed are two sides of the same coin. In the stock market, the emotions of fear and greed cycle back and forth with the daily price movements and economic cycles. As investors become more risk averse and begin to focus on what they don’t have instead of focusing on protecting what they do, the mindset switches to one of embracing risk in search of higher returns. They also fear being left behind as prices rise, fearing they’ll regret that they’re missing out by not buying now, sowing the seeds for the end of the advance. When the cycle shifts to an environment of contraction, the opposite drives investor thinking and fear of regret from not selling at higher prices leads to panic to protect what they still have.
Fear of negative consequences can lead to taking actions that are detrimental to our financial situations, panicking as those around us do the same. Behavioral economists have researched why we make decisions under uncertain circumstances and have found that the system of fast reaction in our brains born out of necessity to stay alive, cause us to react without thinking through the probabilities or consequences. The same system that kept our ancestors alive while foraging for food and looking for shelter from predators is hardwired in humans, and this fight or flight instinct can lead us to sell as the cacophony of reasons inundate our brains.
How can we avoid falling prey to our instincts and not acting when the emotions of fear and greed take over? By working with a financial professional who can help save us from ourselves. Planning for these types of market environments ahead of time, we can stick to our pre-determined script for how to react to fear and uncertainty. Basing our investments on risk parameters rather than trying to earn the highest return possible will allow us to build wealth through entire market cycles, because the cycles are unavoidable. There were plenty of Dot Com millionaires that were left with nothing after the bubble burst and plenty of real estate developers that lost more than they were worth in the housing crisis, only by controlling fear and greed is greater wealth possible.
Lesson Number Two: Have a no regret portfolio in addition to your stock portfolio.
Investing is a trade-off between how wealthy we want to be in the future and the emotions of fear and anxiety that we have to go through to achieve that wealth. Wealth accumulation takes time, but if you are consistent it will happen, it’s inevitable.
In order to make it through the rough patches, set aside some money in a fixed income portfolio so that when stocks are declining you have a portfolio that will provide stability and income. The role of bonds is to provide diversification from stocks, preserve capital, and generate income no matter the environment. They’re not for maximizing return.
By having two portfolios, one for stocks and one for bonds, we can minimize the regret of not selling stocks at higher prices or not participating in a bull market.
Lesson Number Three: Keep a rainy day fund.
When all your money is tied up in investments or real estate you lose a safety net and the ability to move quickly if an opportunity presents itself. If you’re worried about losing your job and how you’re going to meet your monthly obligations, your mindset changes and you lose the chance to take advantage of a temporary decline in prices. As Warren Buffett says, “Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
There were plenty of cash ready buyers for homes in Phoenix when they were selling for half off in 2008 and 2009. In the years since investors purchased these distressed assets the value of the properties have doubled and many investors have received rents providing them with double digit yields, while the people who were over leveraged haven’t been able to get back in the game. If you don’t have any cash, you can’t take advantage of bargains.
Will we experience another time like the fall of 2008? I hope not in my lifetime, but if I had to wager, I would say that we will within my children’s lifetime. The painful experiences of that era will remain etched in our collective society for some time, but eventually those losses will be forgotten and sow the seeds for another crisis.