The Money Managers | In the News

The current financial crisis has been so devastating that it is tempting to believe that it may never be resolved. It is useful to look at past crisis’s and see what lessons can be learnt. Every financial crisis is different of course and the various causes, magnitude and duration will differ but there may be some implications that can help us determine what we should be expecting with our investments in the current situation.

There are some parallels that can be found in the Asian Financial Crisis in 1997 (Thai Baht meltdown), the long Japanese crisis that caused their lost decade of the 1990’s, the Swedish banking crisis of the early 1990’s and the UK secondary banking crisis of 1973 and 1974. In each of these situations the share market was adversely affected and in each scenario except Japans, the market rebounded sharply within a couple of years.

One difference between the Japanese experience and each of the other scenarios was the way the government and financial regulators responded to that crisis. In Japan’s case they failed to respond in any meaningful way and moved far too slowly to rectify the situation when they did recognise it. In each of the other circumstances authorities moved to rectify things in a timely and dramatic manner. Although the experience was painful and the financial industry went through costly restructuring with many individual losers, the system itself was able to rectify the imbalances and move forward.

In each of the cases except Japan, investors in the share market benefited from taking a long term view even after experiencing massive drops in portfolio value around the crisis. In looking at what went on in these past circumstances we can see some commonalities such as a prior boom in asset values and subsequent leverage into the booming market. A trigger caused a sudden drop in asset prices and this predicated problems and failure in the financial institutions that were providing the credit to the sector that suffered the drop in value.

In making investment decisions in the aftermath of such collapses, investors are understandably wary of committing further resources and as a consequence tend to be out of the market at the wrong time. The risk premium and expected future return is highest when most people are most hesitant to invest. There have been many studies that have shown that the compensation for taking risk should be higher during a downturn than when markets are at a peak.

Even though it is extremely painful to experience a significant drop in our asset values during a financial crisis, the fundaments apply now as much as they ever have. There is a positive relationship between risk and return and you can only minimise specific risks by having a globally diversified portfolio. This would have helped Japanese investors in the 1990’s. History has taught us well that during most periods of financial turmoil, withdrawing funds from equity markets after falls of over 50% realises losses that are never likely to be recovered.

Nobody can predict when markets are likely to recover and it is acknowledged that there may be further painful drops in asset prices before the full impacts are washed through the system. Unfortunately this is a risk that investors must bear if they are to be compensated ultimately for taking risk. History shows that in the overwhelming number of cases, investors who hold the line through the difficult times will be rewarded.

You can only expect to earn higher returns if you take higher risks and the current situation is seeing the worst of those risks playing out. As a result of this, risk premiums are higher now that they have ever been. Fortune favours the brave. Investment decisions should be made on a forward looking basis but past experience has emotionally scarred us.

Although it is impossible to predict with any accuracy when the market will start to recover, it will be necessary to be in the market well before recovery begins. The short term uplift from the eventual trough is usually extraordinarily high, particularly after such a vicious downturn. One by one, short term traders are being taken out of the market and investors with longer term time horizons will inherit the wealth gained in the inevitable recovery.

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