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A Retrospective and Lessons for the Next Crisis

| November 01, 2017
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We recently passed the 10-year anniversary of when, in early October 2007, the S&P 500 Index hit what ultimately was its highest point before losing more than half its value over the next year and a half during the depths of the global financial crisis.

Over recent weeks—and in the months ahead—as other anniversaries of major crisis-related events pass (for example, 10 years since the bank run on Northern Rock or 10 years since the collapse of Lehman Brothers), you will no doubt have heard or seen a steady stream of retrospectives on what happened as well as opinions on how the environment today may be similar or different from the period leading up to the crisis. In our perspective, it’s difficult to draw useful, actionable conclusions based on such observations as financial markets have a habit of behaving unpredictably in the short run.

There are, however, important lessons that we believe investors would be well-served to remember:

  • Capital markets have demonstrated a remarkable tendency to recover from periods of crisis;
  • Capital markets have historically delivered generous long-term returns in spite of these periodic crises;
  • Crystal balls do not exist—predicting when these crisis periods will begin (and end) is a fool’s errand;
  • An investor’s best defense against a crisis is having a well-conceived long-term investment approach that is appropriately tailored to their unique financial objectives and situation; and,
  • An experienced, knowledgeable financial advisor can provide effective counsel in helping to craft an investment plan and in helping an investor to remain committed to it when things look their darkest.

The benefits of hindsight

In 2008, the stock market dropped in value by almost half. Being a decade removed from the crisis may make it easier to take the past in stride. The eventual rebound and subsequent years of double-digit gains have also likely helped in this regard. While the events of the crisis were unfolding, however, a future of this sort looked anything but certain. Headlines such as “Worst Crisis Since ’30s, With No End Yet in Sight,”[1] “Markets in Disarray as Lending Locks Up,”[2]  and “For Stocks, Worst Single-Day Drop in Two Decades”[3] were common front page news. For nearly all investors, reading the news, opening up quarterly statements, or going online to check an account balance were stomach-churning experiences.

While being an investor today (or during any period, for that matter), is by no means a worry-free experience, the feelings of panic and dread felt by many during the financial crisis were distinctly acute. Sadly, many investors reacted emotionally to these developments “de-risked” by selling out of their stocks either in part or in whole after concluding the turbulence and losses were more than they could stomach. Many of these investors subsequently struggled in the following years with equally challenging decision of when to “re-risk” or get back into the markets after the market’s recovery was well underway. On the other hand, many investors who were able to stay the course and stick to their investment program recovered from the crisis and benefitted from the subsequent rebound in markets.

It’s important to remember that this crisis and the subsequent recovery in financial markets was not the first time in history that periods of substantial volatility have occurred. Exhibit 1 helps illustrate this point. The exhibit shows the performance of a simple balanced global stock and bond investment strategy following several crises, including the bankruptcy of Lehman Brothers in September of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year during which the specific event occurred or the market peaked prior to turning down.

Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses in the immediate aftermath of each of these events, financial markets did recover. This is clearly demonstrated by the three- and five-year cumulative returns figures shown in the exhibit—cumulative returns were generally positive (often substantially) three and five years following the onset of the crisis. Put differently, a balanced portfolio invested at the onset of each of these crisis periods in many cases ultimately delivered positive returns over the subsequent three and five years in spite of the sharp losses experienced during the crisis period.

The next crisis

In the mind of some investors, there is always a “crisis of the day” or potential major event looming that could mean the beginning of the next drop in markets. As we know, predicting future events correctly—or how the market will react to future events—is an extremely difficult exercise (one needs only to look back on 2016 for multiple vivid examples of unpredictable events and even more unpredictable market reactions). It’s important to understand, however, that market volatility is a part of investing. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty and the associated volatility of portfolio returns.

Experience has taught us time and again that a critical part of successful long-term investing is having the discipline and wherewithal to stick with an investment approach through periods of market turbulence (and euphoria when one can equally be tempted to abandon an well-devised plan). Fortunately, there are concrete actions that investors can take to give them the best chance possible at possessing the requisite fortitude when the next crisis inevitably comes. We believe that a thoughtfully developed investment policy is the most effective antidote to panic. Such a policy should work to ensure: (a) that the investor’s goals, risk tolerance and time horizon are well understood and clearly articulated; (b) that the portfolio’s asset allocation is clearly aligned with the investor’s goals, risk tolerance and time horizon; and (c) that the portfolio is aggressively diversified globally across and within asset classes.

A well-thought-out investment approach sufficiently aligned with an investor’s unique financial circumstances can help all investors to be better prepared to face uncertainty and can dramatically improve their chances at sticking with their plan and ultimately capturing the long-term returns of capital markets. We believe an experienced, knowledgeable financial advisor can play a critical role in helping all investors to work through the issues of crafting an investment policy tailored to their personal situation and in providing much needed counsel when things look their darkest.

 

IMPORTANT DISCLOSURES

Past performance is no guarantee of future results.

Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

All performance referenced is historical and is no guarantee of future results.

No strategy assures success or protects against loss.

Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual investment performance.

The economic forecasts set forth in the presentation may not develop as predicted.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

Stock investing involves risk including loss of principal.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification and asset allocation do not protect against market risk.

Balanced Strategy 60/40

Construction: 42% Russell 3000 Index (US Stocks), 18% MSCI World ex USA Index (Non-US Stocks) and 40% Bloomberg Barclays US Aggregate Bond Index (US Bonds). Rebalanced monthly.

Notes: The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor’s decision making if the advisor were actually managing client money. The balanced strategies are not recommendations for an actual allocation.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Private Advisor Group, a Registered Investment Advisor. Private Advisor Group and Kathmere Capital Management are separate entities from LPL Financial.

[1]wsj.com/articles/SB122169431617549947.

[2]washingtonpost.com/wp-dyn/content/article/2008/09/17/AR2008091700707.html.

[3]nytimes.com/2008/09/30/business/30markets.html.

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