By: Investor Solutions
Few will argue that 2008 was an eventful year not too soon forgotten. From presidential elections to corporate bailouts to plummeting home and stock prices, 2008 was flooded with noteworthy events. And just like we learned in our history class about such events in the past, so too will our grandchildren learn from what happened last year. Let’s reflect on the lessons these events can provide.
What goes up must come down.
Let’s face it folks, the real estate market could not continue to increase (indefinitely) at the rate it has the last few years. It’s impossible. Hard working people with good jobs could not afford to buy a nice house in a good neighborhood without being strapped for cash. I pity those that followed the masses and got in over their heads. The intelligent investor is the one that decided that while the real estate market was skyrocketing, he (or she) was going to continue saving his money for when the inevitable hit. And oh has it hit. The foreclosure rate in 2008 skyrocketed and many homeowners and investors are losing their homes. Enter the Warren Buffets of the world. As I’m sure we’ve all heard him say, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” While few of us are Warren Buffet we can certainly learn from him. At the time when the real estate market started taking off and flippers were raking in the cash, they and others alike got greedy and wanted more real estate so they bought more. Now those folks are struggling to make payments and foreclosing on properties. It’s the Warren Buffets of the world that are bailing them out.
Live within your means.
This may be the hardest lesson to put into practice. For some reason, individuality is a thing of the past. No one wants to be the person that has the little house they can comfortably afford. Few would be caught dead in a car more than just a couple of years old that’s not made by BMW, Mercedes or the like. Nope. Instead, everybody wants what everybody else has. Can they afford it? No, but that doesn’t matter. As long as they have credit, they are going to get it. Reality check – just because you can pay for it, doesn’t mean you can afford it. As far as I’m concerned, being able to pay for something means that you can come up with the cash or credit to cover the cost of it either immediately or over a period of time. If you can afford something it means that getting that item which you covet would not so much as cause a ripple in your financial situation. If you can’t afford it, don’t get it. Keeping up with the Joneses is overrated.
Your brokerage account shouldn’t be your emergency fund.
Maybe you know someone who invests in the stock market and figures that when they face a financial emergency, they will simply sell a portion or all of those securities and use the proceeds to cover this unforeseen expense. Bad idea. This strategy would have been completely blown out of the water in 2008. With an increasing unemployment rate and significant losses in the real estate and stock markets, using a portfolio invested in equities as an emergency fund is a foolish strategy. As a rule of thumb, individuals should have three to six months worth of expenses in cash. Don’t use stocks or mutual funds as a “safe” place to store your emergency fund. Instead, look into money market accounts and certificates of deposit insured by the FDIC to keep these funds easily accessible and free of market fluctuations.
A sound investment strategy doesn’t outperform every time
Even the most thought out, sound investment policy does not come with guarantees. We should all know by now that a globally diversified portfolio reduces risk and increases return. Unfortunately, that doesn’t work 100% of the time. No matter how well diversified a portfolio, it still has market risk which manifested itself last year. For example, an individual who invested all of his money in the S&P 500 during 2008 would have suffered a loss of approximately 36%. However, an individual with a globally diversified portfolio would have suffered a loss closer to 42%. On the occasion that the S&P is the best performing asset class, an alternative portfolio with additional asset classes would have outperformed. This doesn’t mean that everyone should hold a portfolio invested solely in the S&P 500. One should always diversify his portfolio and include fixed income to the extent that his risk tolerance suggests. However, we need to be cognizant of the fact that such a strategy will work in the long term even though there may be hiccups along the way.
Our risk tolerance is lower than we thought.
Someone invested in a 100% equity portfolio during a bull market thinks they have a high risk tolerance. However, when markets are not behaving as robustly as we would like, as in 2008, that risk tolerance drops significantly. Here again the words of Warren Buffet about greed and fear come to mind. Don’t overextend yourself to earn additional return if the consequences of that strategy backfiring keep you up at night.
Two thousand and eight was a tough year full of successes and disappointments and the best thing to do is focus on the positives. Learn from what happened and apply those lessons to future strategies and circumstances. In the words of philosopher and poet, Georges Santayana, “those who do not study history are doomed to repeat it.”