In MONEY WISE, I wrote a chapter on risk, emphasizing the four root causes for investments turning out badly: Overconfidence, Personality Change, Leverage and Unanticipated Events. Each of these contributed to the loss of capital in 2008.
In late 2007 and early 2008, many recognized that there were storm clouds on the horizon. The problems looked to be excesses on the top of reasonably sound fundamentals. Historically, the general market on average over a ten year period has two declines of over 10%; with the largest decline being less than 25%. Furthermore, history indicates that once in a generation a decline of 50% occurs.
Using this history as a guide, like many analysts I was concerned, but not ready to materially change investment portfolios. Many of us believed we would have a decline followed by a rigorous recovery. Under those circumstances the prescription to avoiding being too smart was to buy and hold relatively high quality securities.
One year later in the fall of 2008 we see a much different landscape. What went wrong?
The first risk ingredient I discussed in MONEY WISE was Overconfidence. Many professionals erroneously thought that experiencing market declines for forty or fifty years would qualify as the complete relevant market experience. Many, myself included, felt that while age does not equate with wisdom, it helps.
Because there had not been a fixed-income led stock market crash since the Great Depression, many of us “equity guys” missed it. Having grown up in the financial services industry, and in many cases on a first-name basis with the CEOs of major firms, I was able to see that most were honest and hard-working leaders with their own fortunes tied up in their companies – thus they were poised to do the right thing. We were all over-confident.
Personality change is another source of risk. (Normally the most prevalent personality change risk is that of the investor, investment committee or key manager.) As the operating baton of management was turned over from experienced, known individuals to younger management, it was logical to assume that they were being replaced in-kind. In many cases, this proved not to be the case as the new leaders wanted to prove that they were better than those they replaced. Some expanded their product and geographical ranges beyond the old footprint. Often the expansions were in products that were unfamiliar to the new leaders, their control mechanisms, and the bulk of their middle management. Thus a change in managers was also a marked “Personality Change.”
Another “Personality Change” of note occurred during this presidential election cycle. Many thought that there would be a continuation of the present policies, perhaps slowed by a bulky Congress. As the campaign progressed however, investors became concerned about comments packaged for the fringe elements on each side. Fortunately the new Administration sounds as if it will be vigorously centrist.
Much has been written about leveraging and deleveraging, but little has focused on the benefit of being correct or wrong about future price trends. In the period of the five years ending in 2006, those using financial leverage have been winners and in many case big winners. The reverse became more evident in late ’07, and made public when their financial statements were published earlier this year.
Much less has been written about operating leverage. Operating leverage occurs when revenues exceed or contract relative to a fixed cost break-even point. During periods of high sales growth, operating leverage produces significantly higher earnings growth than sales growth. Operating leverage is extremely important in high fixed-cost manufacturing industries.
Over the past year, even with the rapid expansion of consumer demand in the major developing countries, world unit growth began to fall. The result was depressed operating leverage and diminished earnings and stock-prices. Ironically, in this case a lack of leverage (operating) contributed to the problem.
The final cause of risk discussed in MONEY WISE is the risk of unanticipated events. In my own case, I recognized many of the structural weaknesses in the financial community, but because they had been there for years, I never expected that they would all arrive at their comeuppance at the same time. We all missed the greater, global, significance of the increasing failure rate in subprime mortgages. The interconnections between the equity markets and fixed-income derivatives were theoretical to many, and the possibility of a simultaneous collision of these forces posed an extreme example of an unanticipated event.
Each of these four aspects of risk and their appearance in 2008 provide valuable lessons for all investors. In the future I hope to use this space to write about understanding additional aspects of risk when building long-term portfolio strategy.
I welcome your own thoughts and your personal risk avoidance strategies.