It’s been 10 years since the financial crisis. Sometimes it feels like a lifetime ago. There were some rocky moments since, but overall things turned much better than almost everyone predicted. That said, nothing’s ever perfect or permanent.
The advantage of history is the ability to revisit past experiences and keep the lessons fresh in our minds. Being a decade removed, now seems like as good a time as any to do that.
In his 2010 annual letter, Seth Klarman wrote about the 20 lessons he took away from the ’08 crisis. The best part is the lessons don’t require another crisis to be useful.
Below, you’ll find an edited excerpt from his letter:
- Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
- When excesses such as las lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation… Correlation between asset classes may be surprisingly high when leverage rapidly unwinds.
- Nowhere does it say investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell.
- Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk.
- Do not trust financial market risk models. Reality is always too complex to be accurately modeled… Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
- Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, meet commitments, or to make compelling long-term investments.
- The latest trade of a security creates a dangerous illusion that its market price approximates its true value.
- A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets.
- You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
- Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather.
- Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
- Be sure that you are well compensated for illiquidity — especially illiquidity without control — because it can create particularly high opportunity costs.
- At equal returns, public investments are generally superior to private investments…because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
- Beware leverage in all its forms… Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
- Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option.
- Financial stocks are particularly risky. Banking…is a highly leveraged, extremely competitive, and challenging business.
- Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
- When a government official says a problem has been “contained,” pay no attention.
- The government — the ultimate short-term-oriented player — cannot withstand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage.
- Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.
Last Call
- Difficult Decisions – S. Godin
- The Equilibrium Delusion – F. Martin
- The Biggest Policy Mistake of the Last Decade – The Week
- The Trajectory of Great Ideas – M. Housel
- Investors are Desperately Trying to Cut Through the Glut of Information – 13D Research
- Unknown Unknowns: The Problem of Hypocognition – Scientific American
- The Unreality of Luck – Aeon
- Maria Konnikova Shows Her Cards – NY Times
- Your Lying Mind – The Atlantic
- Conflict Reigns Over the History and Origins of Money – ScienceNews
- Report: How AI is Transforming the Financial Ecosystem – WE Forum
- The Life of Isaac Asimov – Science Me