Taking stock of financial lessons learned in 2008, 2009

May 1, 2010

Now that we’re showing signs of slowly emerging from one of the worst financial crises in our history, it may be time to look back and try to figure out what lessons we’ve learned from the market crash of late 2008 through early 2009.

Nineteenth-century philosopher George Santayana got it right when he said, “Those who cannot learn from history are doomed to repeat it.”

Now that we’re showing signs of slowly emerging from one of the worst financial crises in our history, it may be time to look back and try to figure out what lessons we’ve learned from the market crash of late 2008 through early 2009.

Perhaps more important, what steps we need to take to avoid stumbling into that dreadful abyss again. Here are a few things worth considering:

Credit is a two-sided sword

Without credit, most Americans would have no hope of ever owning their own homes or automobiles. Without credit, the quality of life for most people would be far less attractive.

But credit, as we’ve learned in recent years, has its dark side, as well. Some experts compare credit cards to drugs; they offer short-term pleasure in exchange for long-term pain.

Sensible and tightly controlled use of credit can be a powerful financial tool, but overuse of credit cards to finance a lifestyle beyond one’s means is a certain road to financial oblivion.

Leverage just another word for debt

On the surface, it looks great. Put a small down payment on equities or real estate and get rich as your investment rises in price, thus greatly magnifying your small investment through the concept known as leverage. In theory, there is no limit to your potential profit using leverage; it is infinite, so long as the price continues to rise. Thousands of investors in highly leveraged residential and commercial real estate quickly became paper millionaires during the infamous real estate “bubble.”

But what happens if the market price of the investment happens to go down as it did when the “bubble” finally burst? When that happens, leverage works against the investor in the cruelest of ways. Not only is it possible to lose your entire investment in the blink of an eye, that same leverage can magnify your loss far beyond your original investment.

Leverage may be fine, but only in the hands of those who understand exactly how it works and are willing and able to take the frightful risk involved.

Don’t follow the lemmings

It seems to be inherent in human nature: Come across a group of people looking up at the sky and chances are you’ll stop and look up. When a stock market crash causes others to sell out in panic, the urge to do the same seems overpowering. Apparently, there’s a degree of comfort in following the crowd. If everyone is doing it, it must be right.

There have been a least a dozen major financial crises in American history, and every one of them has been followed by a rebounding to record-breaking highs. The lesson: a market crash is a great time to buy as many quality stocks as you can afford.

The problem is that such a counter-intuitive move opposes that instinctive urge to follow the crowd. Those rare individuals who have been able to overcome that inner voice have made out very nicely while others are unloading their bargain stocks at bargain prices.

Buffet has the right idea

Warren Buffet, regarded by many as the world’s most successful investor, has a way of putting things simply. “Risk comes from not knowing what you're doing,” he says.

Some of the key villains in our recent crisis are those exotic financial instruments said to lessen investment risk. An instrument known as derivatives is perhaps the leading bad guy in this regard. “Derivatives are financial weapons of mass destruction,” Buffet says.

Even professional managers of mutual and pension funds, without having a clear idea of what they were buying, fell victim to the zealous selling pressure by the promoters of these instruments. The results were catastrophic for many.

Buy home for shelter, not investment

As it turns out, too many people bought their homes as a savings and investment strategy in recent years. That seemed like a fine idea while real estate prices were rising so fast that selling a home bought ten years earlier would probably bring a handsome profit when the time came to sell.

However, real estate, like every other form of investment can and does go down as well as up in price. Easy credit with mortgages oversold to buyers with marginal qualifications resulted in millions of homeowners waking up to find their homes worth less than what they owed on their mortgages.

A home, the largest single investment that most Americans will make, provides comfort and protection for the family. In many people’s minds, home ownership is fundamental to the American Dream. But careful shopping for a home that fits the family’s financial capability is the only sensible way to fulfill that dream.

These are just a few of the painful lessons that our most recent financial crisis has wrought; perhaps the most important being that living beyond our means is taking up residence in a fool’s paradise.