Investment Lessons from the Financial Crisis

There's a great article in this month's AAII Journal on what we all should learn from the financial crisis and bear market. I'm going to summarize it here and add a few comments of my own. All quotes are from the article "Bear Market Grads: What You Should Learn from the Financial Crisis," by William Reichenstein and Larry Swedroe, AAII Journal, July, 2009.

1. Mix high-grade bonds and stocks to lower portfolio risk.

High-grade bonds and stocks are fundamentally different assets. Bad years for stocks are sometimes good years for high-grade bonds, and vice-versa. High-grade is the key qualification here, meaning highly-rated corporate or government bonds. I don't know much about bonds myself, so all my bonds are held via mutual funds. Avoid junk bonds, also known as high-yield bonds. The reason they have high yields is that they are risky, and their value tends to move up and down in tandem with stocks. That eliminates their diversification benefits, which is what you are seeking.

2. Avoid complex investment products.

"Wall Street likes to create complex products that appear desirable, but are designed to separate capital from investors." Personally, I consider anything with even a single level of indirectness (that is, a derivative value one or more levels removed from the value of the underlying asset itself) to be too complex for me. I have never bought an option (put or call), nor a future. I have never sold short, nor used leverage (margin). I know many investors who design complex strategies around such instruments, but I like to keep it simple: I either own stocks or I don't, own bonds or not. No derivatives. Any investment that has to be sold (via seminars, free lunches, and the like) is dangerous. Just say no.

3. Stick to simple, transparent investments.

"Individual investors can create prudent portfolios by combining stocks, bonds, mutual funds, and exchange-traded funds." I would add, of course, cash (money-market funds and certificates of deposit). "They do not need to resort to non-transparent products like CMO's, CDO's, hedge funds, and funds of hedge funds....Investors should not trust opaque strategies that seem to offer returns that are too good to be true." Bernie Madoff's clients would second that.

4. Avoid leveraged investments.

There is already risk in any investment other than cash. Leverage, of course, means borrowing--that magnifies returns, either up or down, and therefore increases the inherent risk already there. Again, many investors use leverage heavily (buying stocks on margin, for example). I don't. Besides magnifying the risk, the loan itself costs money (the interest on the loan). Practically every huge financial blow-up during this financial crisis has involved heavy leverage. If the experts (banks and investment companies) can't get it right, you probably can't either.

5. There is no "smart money" or investors who are consistently smarter than others.

Actually, I disagree with this one. I know what the authors mean: That some experts are using inside information, superior investment models, greater access to information, or outright manipulation to get better returns. That Wall Street only employs the "best and the brightest," and how can you compete with them? But to me, any individual investor can be smart by following simple guidelines such as in this article. That's why the article is presented. I turn the statement inside-out: There is certainly dumb money and investors who are consistently stupider than others. They make the same mistakes repeatedly. Don't be one of them. You can be the smart money. Use common sense, stay within your circle of competence, and you will be way ahead of many investors.