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Lessons From The Fall

I'm glad 2008 is behind us. But for generations to come, we'll still be discussing the Crash of 2008. Much like The Great Depression, parents will use their experiences to teach their children strategies and principles about money. Like most historical events, the best perspective will be seen several years after this financial crisis has ended. Here is an early attempt to identify lessons from this dramatic market fall.

1. The stock market is impacted by emotions. In the 90's, Alan Greenspan called it "Irrational Exuberance." October of 2008 may be referred to as "Irrational Fear." After he reviewed the previous year’s economic data and concluded that the depth of the 2008 panic was not justified by the economic data, Milton Ezrati, Partner and Senior Economist and Market Strategist for Lord Abbett wrote, "… those original economic fundamentals matter less than the adverse economic effects of this recent financial strain. If the conditions fail to recover sufficiently now, market fear will dominate economic directions more than any of those original fundamentals. Investors will have created their worst fears—a self-fulfilling prophecy if ever there was one." (From Economic Insights, October 24, 2008.) I'm not questioning the severity of this recent economic crisis. But "panic" and "fear" were the emotions that dominated market decisions in October of 2008. Painfully, we've learned that it can be a dangerous situation when hopes, dreams, and/or day-to-day needs depend on accounts which can be impacted by human behavior. Click here to see a graph on the emotions of the market.

2. The media and politics can feed market emotions. What is the purpose of cable business programs? The answer: "to make money." The goal of any program is to have viewers return for the next program. In addition, they want more viewers. So is it any wonder that dramatic statements and heightened fears are used to draw people back for the latest news? Imagine how different October of 2008 would have been if every night there had been calm, reasonable, reassuring financial reporting in the midst of the global crisis. Whether it is cable news, financial magazines, or financial books, consumers need to critically evaluate whether the news, commentary or information is truly useful or is simply a part of a marketing strategy. Similarly, an election year tends to have a negative economic component to help make the case for change. Once again, we need to be very careful with our dependency on financial reporting that can be so easily impacted by media or political tactics.

3. Even many of the most informed investment professionals missed the indicators. In his October 13, 2008 E-Column, Bob Veres, an industry analyst and author, wrote: "I think we can all agree that the executives at the SEC, Fed and Treasury have access to highly-detailed information, and they are usually intelligent and focused observers of the market and its various tea leaves. And yet, over and over again, at virtually every turn, they seem to have missed all the warning signs that we now think, in retrospect, were obvious. My conclusion: they must not have been nearly as obvious as we now think."

4. Fixed whole life insurance can be a significant component in wealth building. Traditional whole life insurance offers a wealth-building strategy which may be separate from market volatility. Securing a permanent death benefit may be a permission slip to spend other assets—or allow for market declines—knowing that a future death benefit will replace the consumed or lost wealth. Cash values in a fixed whole life insurance policy offer liquidity and a pool of capital which can provide a level of security while variable accounts are declining.

5. Riding through market fluctuations might be a better strategy than moving assets to safety. When shares worth $100 drop to $70 that is a 30% decline. For $70 to return to $100, it requires a 43% increase. If the investor runs to safety when he or she has experienced a 30% decline, there is the potential of missing a significant rebound. Click here to see a study on market timing. (Note: Past performance does not guarantee or predict future performance.) Click here to read a study of market performance during the past 10 recessions.

6. Diversification is important. In 2008, many professional investors said there was no place to hide. Here is a sampling of asset classes that declined from January 1, 2008 to November 1, 2008: investment grade corporate bonds, non-investment grade corporate bonds, municipal bonds, U.S. stocks, international stocks, emerging market stocks, real estate, and many commodities. Though this is the experience of 2008, it is not typical. It is also impossible to predict which asset class or classes will rebound in 2009. Click here for a study of past asset class performance. Note: Diversification does not guarantee against loss. It is a method used to manage risk.

7. Preparing for financial crises begin with picking quality companies. The best time to prepare for a global economic crisis is before it happens. It is important for consumers to investigate the quality of the financial companies they are trusting to manage their monies. Even old, quality companies failed in 2008. Yet, many of those companies failed due to their appetite for leveraged risk. It is not uncommon for a consumer to make an investment or insurance purchase without asking questions or researching the quality of the company. At Woolman Financial Group, our desire is to help clients understand how to pick quality companies. Click here to see a report on one of our primary insurance companies.

8. We can't control the economy, but we can control our savings rate. In good times and in bad times, we believe our clients should be saving at least 15% of their gross income. Certainly, there are times when income drops and this may be impossible. But we need to focus on the "input" side of the equation. We can’t rely on past performance or current assets to determine whether or not we need to save for the future.

9. Having liquidity is essential. We teach our clients to work towards having at least half of their gross income in conservative, liquid accounts. In the midst of a recession, cash not only provides a safety net for potential employment changes, but it also can be utilized for purchasing assets that may be selling at a discount. For retired clients or pre-retirees, having at least two to three years of needed expenses in cash is important.

10. A macro-economic approach is the best way to create financial strategies. Were the investment bankers thinking of the "macro" (the big picture) when they sold risky loans? Financial institutions have become bankrupt partly due to singular (micro) thinking—they did not adequately consider the global ramifications of their lending decisions. The lesson for consumers is to think macro. With our clients, we use a macro-economic process which helps people to make financial decisions in light of how it impacts other financial decisions. This does not guarantee success, but it is an effective decision-making tool which helps us increase the effectiveness of our financial decisions.

Important Disclosure Information:
Diversification does not guarantee against loss. It is a method used to manage risk. Guarantees are based on the claims paying ability of the issuing insurance company. This information should not be considered as tax advice. You should consult your tax advisor regarding your own tax situation.
Tracking # 36297, DOFU 1/1/2009

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