Learning from Investment Bank Mistakes

“The key to successful investing is to get the plan right and stick to it. That means acting like the lowly postage stamp that does one thing, but does it well: It sticks to its letter until it reaches its destination. The investors’ job is to stick to their well-developed plan (if they have one) until they reach their destination. And if they don’t have a plan, write one immediately.” – Larry Swedroe

What can investors learn from the mistakes of investment banks, such as Lehman Brothers and Bear Stearns? That question is what Larry Swedroe addresses in his article: Anatomy of a Crisis: Lessons Learned From the Credit Crunch.  Swedroe believes that one should not judge a strategy “solely on the outcome.” Nevertheless he identifies the “major strategic errors” investment banks made.

First, they “bet the house” by using too much leverage, meaning the company would go bust if these bets lost. Highly leveraged institutions must be right all the time because even if they are correct in the long term, they may not weather a short-term storm. This is a lesson these institutions should have learned from the 1998 experience of hedge fund Long-Term Capital Management (LTCM).

Second, they failed to effectively diversify risks, placing too many eggs in just a few highly correlated baskets (such as residential and commercial real estate).

Third, they forgot that even if assets have low correlation, risky assets have a nasty tendency to have their correlations turn high at the wrong time.

Fourth, they treated the unlikely (housing prices falling sharply) as impossible. They also forgot that just because something had not happened does not mean it cannot.

Fifth, they failed to understand that liquidity can be illusory: there when you don’t need it, but “gone with the wind” when you do.

Lessons Investors Should Learn

1. Investment banks and active managers (including hedge funds) cannot protect investors from bear markets. All crystal balls are cloudy … If their money managers could protect you, why did Lehman Brothers and Bear Stearns go belly up and Merrill Lynch have to run into the arms of Bank of America to prevent the same fate? …
2. Never take more risk than you have the ability, willingness or need to take.
3. Diversify broadly, and don’t concentrate labor capital and financial assets in one basket. Many employees of once-great companies lost not only their jobs but also much of their financial assets because they made this mistake.
4. For fixed-income assets, stick only with government bonds and the highest investment-grade bonds. Anything else (such as junk bonds and preferred stocks) can have the risks show up at the wrong time.
5. We live in a world of uncertainty (the odds of events occurring cannot be measured), not a world of risk (the odds can be measured). Thus, stocks are high-risk investments, no matter how long the investment horizon. That is one reason for the large equity risk premium.
6. Treat neither the unlikely as impossible, nor the likely as certain. And, if something has not yet happened doesn’t mean it cannot or will not.
7. Make sure your investment plan incorporates the high likelihood of crises. The only way to avoid them is to not take risk, and thus accept Treasury bill returns. While bear markets are painful, there is no good alternative to buy and hold except to avoid risk. Timing the market is a mug’s game.

As further evidence against the folly of market-timing efforts, a study on 100 pension plans that hired the “best managers” around to engage in tactical asset allocation (a fancy term for market timing) found that not one had benefited from the efforts.