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Tuesday, December 30, 2008

Financial Credit Crisis: Lessons Learned

Financial Credit Crisis: Lessons Learned By Zhuge Liang

Even at the height of a great bullmarket successfully navigating the financial markets is a challenge for investors. This challenge is magnified exponentially during market crises. It is at these times that solid investing fundamentals pay the greatest dividends. Indeed, investment lessons reinforced during these difficult periods can enhance an investor's chances of success not only during the crisis, but also throughout future market cycles. With that in mind, this final chapter of the tutorial will examine important investment lessons that can be learned from the credit crisis.

Investing During Times of Turmoil
There's recently been a joke making the rounds among traders. "If you can keep your head when all around you are losing theirs," the jokers say, "you haven't been paying enough attention." This gallows humor generates a few chuckles, but the investing principle that it parodies holds the key to success during times of market turmoil.

It is difficult to avoid buying into a market bubble. No one likes to watch from the sidelines while everyone around them makes money, but history has shown again and again that market bubbles always burst. Some investors may have impeccable timing and may be able to ride the bull to its apex before selling at just the right moment; however, these fortunate souls are rare indeed and their unique talent is probably not a successful recipe for the average investor.

Once a bubble has burst (and they always do) the ensuing decline can be even more emotionally challenging than the bubble itself. While bubbles usually occur over time, crashes can occur with stunning rapidity. During these times, the sense of fear in the market can become so palpable that is easy to understand why some market crashes have been labeled "panics".

All investors experience the emotions of greed and fear during market bubbles and crashes. Recognizing this fact and accepting that markets often behave irrationally can enable an investor to step back and objectively evaluate the financial markets. Successful investors are able to adhere to their investment plans, regardless of the current direction of the herd mentality. In fact, truly great investors often possess the ability to act contrary to the herd. Investors who are willing to sell when others are greedy or buy when others are fearful usually experience great success over the course of their investment careers.

Timeless Investment Lessons

1.Have a plan and stick to it.
There are countless paths to financial success. However, investors that blindly rush from one strategy to another rarely prosper in the long run. Investors who find a plan that they are comfortable with and stick to that plan across market cycles stand a much better chance of reaching their financial goals.

2.Remember that fundamental value always matters in the long run.
Investment valuations often do not reflect fundamental value because the behavior of market participants is commonly irrational. Nevertheless, over time, markets always return to long-run equilibrium. This was demonstrated during the credit crisis by the sharp declines in the value of many previously inflated asset prices. This will also be demonstrated when, over time, the prices of quality assets once again increase to their true values.

3.Always focus on risk management.
Portfolios can carry too much risk, either intentionally or unintentionally. While risk does not have to be avoided, it does have to be managed. This principle is important during crises or bear markets, but it is even more important during bull markets and bubbles.

4.Do not rely on third-party opinions.
Research analysts and credit rating agencies serve valuable functions, but they are not infallible. These resources provide an excellent starting point for conducting investment analysis and building a portfolio. However, successful investors conduct their own independent research in order to verify the opinions of these third-party sources.

5.Markets can stay irrational longer than you can stay solvent.
This lesson is especially important for investors who use leverage. Market valuations often reach absurd levels either on the upside or the downside. While these valuations always return to their proper levels, it may take an exceptionally long time for them to do so. Investors need to decide on their risk tolerance and then adhere to it regardless of the market's seeming irrationality. Doing so will prevent the kinds of catastrophic losses from which investors never recover.

6.Try to separate emotion from action.
It is only natural to experience wide emotional swings during volatile markets. Even the most successful of professional investors grow concerned when markets plummet. The difference between truly successful investors and average investors is that the successful investors do not act on their emotions. They feel their emotions, they acknowledge their emotions, and then they continue to invest according to their long-term plans.

7.Make sure you can pass the "sleep test".
If, outside of market hours, investors finds themselves worried about their investment portfolios, it is likely that they are taking too much risk. Sleepless nights brought about by concern over market declines often indicate that a portfolio would benefit from a reduction in overall risk and a shift to safer assets.

This article has examined important lessons that investors can learn from the financial credit crisis. These lessons are not new; they have always been key principles for long-term investment success. However, during bull markets it is easy to forget the fundamentals. In fact, many investors profit during a bull market regardless of their investment approach. These profits can even wind up providing negative reinforcement for bad habits and can prevent an investor from developing a successful, disciplined, long-term investment strategy. Remember, there is a reason that long-time Wall Street traders like to say "never mistake a bull market for brains".

The key to long-term financial success is not simply to profit during bull markets, but rather to manage a portfolio across market cycles with an aim toward maximizing risk-adjusted returns. Over time, investors who incorporate fundamental investment principles into their strategies will have a much better chance of generating superior risk-adjusted returns With that in mind, if investors use the unprecedented events of the credit crisis to develop a solid understanding of fundamental investment principles, they may one day look back on this difficult period and recognize that it served as the foundation for their future success.


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1 comment:

ivy said...

Hi ZL,

Luv this article very much! Stay with it -- you are doing just fine!

We know and we have heard about the importance of discipline a hundred times. Unfortunately, discipline and emotional control is where the majority of people fall down in their trading.

Trading discipline rests upon trade planning. The trade plan sets out in advance the range of possible options for price activity. It tells the trader how to recognise when the trade is moving in his favour, and how to recognise when the trend is changing direction. It provides an entry signal, and the conditions for exiting the trade to protect a profit or cut a loss.

Trading discipline is the traders’ ability to follow the trading plan. When markets dip and there is general panic in the air, it takes discipline to stock with the trading plan. It takes courage to back your analysis. Trading discipline means that success can be repeated, and errors consistently avoided.
Trading success rests upon repeatability. Success is not a gamble, or a stroke of luck. It is the repeated application of a sound trading plan implemented with discipline. This is the real trading edge.

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