During my March 2010 holiday in Singapore I started
thinking about how best to summarise the lessons I have learnt from the
financial crisis.
It was very sure as to what my biggest lesson was. It was the
realisation that it's far more difficult for me to buy during a market
panic than what I thought it would be.
I can still vividly remember me looking at companies in the first
quarter of 2009 and wondering if I should buy if the company was trading
at a price earnings ratio of 3.4, no debt and a reasonably recession
resistant business model. I just didn't have the courage to buy.
What I also did was extrapolate the most recent past into the future, a
classic behavioural mistake.
Once the market started falling I did not believe it would stop and that
the crisis would continue. This thinking also prevented me from buying
when the market turned around as I kept on thinking that the next leg
down was imminent.
Just as I was putting my thoughts together to write my list of lessons James
Montier (at GMO in London) published his list of
lessons not learnt during the crisis in an article called Was it all just a
bad dream? Or, then lessons not learnt (free registration
required)
I have been following James’s writing since 2007, he really
knows what he is talking about.
So rather than me trying to reinvent the wheel here's a short summary of
the 10 lessons. They do not do the original justice which is really
worth 10 minutes of the time.
Lesson one - Markets are not efficient
James has convincingly argued in a lot of previous writing that the
efficient market hypothesis is dead. If markets are efficient how can
bubbles develop and then burst?
Markets may be efficient some of the time but at times completely
irrational.
Lesson two - Relative performance is a dangerous game
As I've said in the past the only thing that matters is the year on year
real growth in your net worth irrespective of what the markets does.
James is of the same opinion and quoted Sir John Templeton which said
that the true aim of investment is the "maximum total real return after
tax".
I could not say it any better.
Lesson three - The time is never different
As soon as you hear the phrase “this time it’s different” you better
make sure that you start running in the opposite direction.
The phrase was used a lot during the Internet bubble when analyst were
saying that profits didn’t matter any more but clicks and eyeballs did.
Well, we al know how that ended.
Before the current crisis statements like house prices can keep on
increasing irrespective of the multiple to income, and that homes
refinancing can continue to be used as ATMs without any consequences.
It was not any different and it will never be.
Lesson four - Valuation matters
Successful investing is really a very simple process.
You look for undervalued investments, you analyse them, and should you
be convinced of the merits you invest. Should you not find anything
undervalued you hold cash.
Or, more importantly, avoid buying expensive assets.
Lesson five - Wait for the fat pitch
This goes along with the previous lesson.
We should wait until you find something really undervalued and then
invest.
And just as I mentioned above is exactly where I failed. I was about 80%
in cash and when stocks really became cheap in March 2009 I was too
terrified to buy. I just did not have the courage.
Lesson six - Sentiment matters
James argues that investor returns are not only affected by valuation
but that sentiment also plays a part.
What it comes down to is that markets are really driven by fear and
greed.
James mentions a study by a Baker and Wurgler which found that when
sentiment is low the best profits can be made by buying young volatile
and unprofitable companies and when sentiment is high it is best to buy
mature, low volatility profitable companies.
This may sound counter-intuitive but isn’t really. It just shows you
that you should invest against the crowd.
Lesson seven – Leverage can't make a bad investment good, but it can
make a good investment bad
The problem with leveraging an investment is that you are no longer your
own master, as it reduces your ability to hold your investments in
times of extreme price falls.
Irrespective of how irrational a price fall may be, margin calls and
security deposits can force you to sell an investment at its lowest
price.
And, to add insult to injury, leave you with little or no capital to
make any further investments to recoup your losses.
As soon as you use leverage you lose this flexibility.
This is what happened in crisis when people became forced sellers
because of leverage. This started an avalanche with more investors
having to sell because of prices continuing to fall.
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Lesson eight – Over-quantification hides real risk
