Five years after the financial crisis — progress and lessons

Five years after the financial crisis, where do we stand in terms of progress and what important lessons have we learned?

The post-crisis progress

In 2008, the financial system was on the edge of collapse. The crisis quickly spilled over from Wall Street to Main Street, triggering the worst economic downturn since the Great Depression. Millions of Americans lost their jobs, homes, and experienced a significant erosion of their wealth — which fell by $19 trillion during this period.

Today, the markets and economy are in much better shape. Enormous monetary and fiscal stimulus prevented a depression-like scenario from happening and helped to restore the financial system and restart our economy. As a result, there have been many improvements since the crisis. Here are just a few of the notable ones:

• Household net worth (includes homes, financial assets, deposits, and pension funds minus liabilities) recovered and reached almost $75 trillion in the second quarter of 2013 — the highest level since the index was created in 1945. Overall, many Americans continue to reduce their debt levels and repair their balance sheets.
• Home prices appear to have bottomed in 2011 and continue a recovery. In fact, the first half of 2013 recorded some of the fastest gains in home prices in recent years, as reported by the Case-Shiller index, a gauge of residential real estate prices.
• Financial markets have more than recovered. The S&P 500 is hovering around 1,700, a more than 170% increase since its 2009 low and a 20%-plus increase since its prior peak in 2007. This remarkable turnaround can, in part, be attributed to the Fed’s highly accommodative policy and improving economic fundamentals.
• Corporate profitability has improved significantly. In fact, after-tax corporate profits as a percentage of GDP are around 10% — all-time highs — and well above the 50-year average of 6.3%. In addition, many companies have reduced their debt and built up large reserves — sitting on record levels of cash.
• Manufacturing is returning to the U.S. — a very exciting element of the recovery story. The U.S. is becoming more attractive as a manufacturing destination. Lower energy costs, innovation, and a more productive labor force are fueling this manufacturing renaissance — and positively impacting economic output and job creation.

While some of the unconventional measures taken by the Treasury and the Fed to stabilize the economy are open to debate — and we have yet to see a full recovery in terms of unemployment and economic output — they have set us on the path to recovery. Yes, there is still a lot more work to do, especially on the fiscal policy front, but the progress up to this point has been considerable.

What did we learn?

Every financial crisis offers valuable lessons if we take the time for reflection. It is crucial to step back and assess our past investing decisions. Looking back, four key lessons are clear – stay the course, diversify assets, turn off the noise, and avoid our own biases. Often, the most dangerous four words in investing are: “this time is different.” It usually is not. Let’s take a closer look at why these four core investing lessons have not changed and are as important as ever:

Stay the course

One of the most important lessons to remember from this recent crisis is to stay the course. This was certainly not an easy task for most investors given the turbulent market during the crisis. It is unfortunate that many investors exited the market at exactly the wrong time and some never returned.

While it might seem tempting to time the market, emotions pressured many investors to buy right at the highs in 2007 and sell at the lows in 2009. During the crisis and its aftermath, investors who jumped in and out of the wildly fluctuating market more often than not became victim to its roller coaster gyrations. As a result, their portfolios often experienced significant losses and some never fully recovered. Those investors who did not get back into the market missed out on a powerful recovery. Since its 2009 lows, the market has rebounded significantly and has even hit record highs recently.

Overwhelming evidence in recent studies shows that, on average, most investors fail to time the market successfully on a consistent basis. Markets are pretty efficient as they incorporate most available information into prices very quickly. Investors are better served by focusing on their long-term goals.

Diversify your assets

Some media have reported that the value of diversification vanished during the crisis. Yes, correlations (how assets move in relation to each another) increased among select asset classes during the crisis. However, the overall benefits of a well-diversified portfolio remain powerfully intact over time.

Diversification is one of the most fundamental principles of sound and prudent investing – making it one of the most valuable tools for investors. Market returns often vary considerably from year to year. Last year’s winner is typically not the best performer in the following year – as last year’s loser may be this year’s winner. To help manage these unpredictable market returns, investors should strategically diversify their holdings.

Many investors think that diversification refers to simply holding a large number of investments, but this is not enough. The key is to combine asset classes that effectively offset each other (they have a low correlation) and behave differently during market ups and downs. This means incorporating asset classes such as alternatives (managed futures or master limited partnerships) to further diversify, or tilting portfolios to specific risk factors (size, value, momentum or expected profitability) to improve the risk/return profile of a portfolio. Diversification of asset classes over a long-term horizon reduces the volatility associated with these market fluctuations.

Turn off the noise

The media generate a lot of unnecessary noise that can impact our investing habits and steer us away from our long-term financial goals. During the financial crisis, there was an avalanche of gloomy headlines from the popular financial media. The constant media noise and speculation pressured many investors not to stay the course.

The recent U.S. fiscal impasse in Washington D.C. while an important issue, is an example of nonessential noise from a longer-term investing perspective. The beginning of October started with the government shutdown and then shifted focus to the debt ceiling battle. The biggest market fear was that if no agreement is reached on the debt limit, the Treasury would be unable to issue any debt and would simply run out of cash to pay its bills. This type of an outcome could have potentially triggered a financial panic similar to Lehman’s collapse five years ago.

Should we be re-positioning our portfolios in anticipation of certain outcomes from Capitol Hill’s fiscal standoffs? Investors cannot precisely anticipate these events as the outcome is simply beyond their control. While we don’t ignore these significant issues, we also don’t make investment decisions around events that may or may not happen next week. One important rule to remember is that to grow our wealth, we must look beyond the short-term noise and invest for the long term.

The media feed off of people’s emotions. Not only must we guard ourselves from the constant media noise and speculation, but we also have to be aware of our own biases that get in the way of our investment decisions.

Avoid our own biases

We can be our own worst enemy when it comes to investing. Especially during a crisis environment, rational thinking can easily check out as our emotions are put to the test. Emotional and cognitive biases are very common traps for investors. These biases include overconfidence (the tendency to overestimate our abilities – “I’m the best stock trader!”), framing (investors can draw different conclusions on the same information depending on how it is presented – especially by the media), and anchoring (the tendency to rely too heavily on a particular trait or data point such as the S&P 500 at 1,700 – does it really matter?).

Most of these biases hurt investors as they cause them to over or under-react to information. Many investors make investment decisions based on emotion or gut feeling rather than on rational thought. During a crisis, a decision might seem perfectly rational, when in fact it is driven by emotion. Understanding the role these biases play in our investing habits is key to making better investment decisions.

Controlling your emotions during a crisis is easier said than done, but that’s where an experienced advisor can provide valuable context and historical perspective. We are here as experts, and listeners, as well as guardians of your wealth. A good investment process helps to minimize these biases and to focus on what really matters.

Where do we go from here?

Whether it is a full-blown financial crisis or a fiscal budget battle on Capitol Hill, our task is to prudently navigate in any market environment, not to get swayed by the noise, and to focus on what really matters – preservation and growth of your wealth over time. It is that discipline – the ability to stick with a sound long-term investment plan – that separates prudent investors from market speculators and gamblers. Investing with discipline is not easy.

Sources: U.S. Department of the Treasury, Financial Crisis Response, April 2012; Federal Reserve, Household Net Worth Report, September 2013; Federal Reserve Bank of St. Louis, Economic Data, 2013; The

Boston Consulting Group, U.S. Manufacturing Nears the Tipping Point, 2012; J.P. Morgan Asset Management, Guide to the Markets, 2013

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