There is one, simple truth common to surviving a financial crisis. But you won’t find this truth buried on a chart or graph. Instead, you will find it on the battlegrounds of World War II.
In 1944, a specialised unit of the Allied Army made a discovery. They didn’t need more firepower. They just needed to look like they had more. Welcome to Operation Quicksilver. The team constructed an artificial ‘Ghost Army’ with inflatable tanks, fake radio transmissions and sound trucks.
This ground force looked menacing to the airborne enemy. A closer look revealed it was just theatrics. Everything was hollow. Herein lies the truth behind all financial crises. They’re built upon deception.
1.1 What we’ll teach you
A financial crisis never looks like one until it’s too late. In fact, in the beginning, a crisis looks beautiful. A revolutionary investment idea or opportunity promises fast wealth. As more people ‘buy-in’, literally and figuratively, the more the perception becomes a reality.
In this article, you’ll learn:
- – Why a financial crisis is hard to spot
- – Signs to see a financial crisis coming
- – How to protect yourself against a financial crisis
Understanding a financial crisis is important. Because without knowing stock market risks you cannot reap the rewards. To be a successful self-directed investor, you need to know where the traps lie.
We’ll reveal them.
A three-part solution
We’re on a mission to foster a generation of self-directed investors. Empowering others means discussing both the risks and rewards involved. In this piece, we focus on the risks. By the end of this article you’ll:
- Learn why a financial crisis is difficult to spot.
- Learn how to spot one before it impacts your savings.
- Create a step-by-step plan to bulletproof your portfolio.
The famous adage reminds us to ‘Keep your friends close and your enemies closer.’ In the next three sections, we’ll uncover the enemy: risk.
1.2 Why is a financial crisis difficult to spot?
Understanding market risk
A financial crisis emerges from what is called ‘market risk’. This risk comes from large economic factors impacting the entire market. These factors are difficult to isolate because they’re connected to each other. Moreover, initially, they move in a direction opposite to what we experience when a financial crisis ensues. This phenomenon is the calm before the storm. How can we tell when we’re in this quiet period? Look at the crowds.
Billionaire investor Warren Buffett understood the power of crowd mentality better than most. He famously warned:
This sentiment would be useful if only we could measure fear.
Fortunately, we can.
How do you measure investor fear?
The Chicago Board of Options Exchange (CBOE) has a Volatility Index (VIX). Many just refer to it as ‘The Fear Index’. The chart represents the expected stock market volatility over the next thirty days. In short, when the VIX is low? Investors are optimistic. Investors are fearful of the future when the VIX is high. They believe the market will fall.
If a high VIX signals volatility then we only need to watch for spikes in the chart.
Why? Because by the time the VIX jumps, the catastrophe has already occurred. It’s too late to act on the data. The market is simply responding. Investors are trying to mitigate losses that they’ve already incurred.
During the most recent financial crisis, the VIX peaked on November 22st, 2008. However, by that time the S&P 500 had already dropped 45.52%. A ‘Check Engine’ light isn’t much good if it only comes on when the car is already dead.
Conversely, when the VIX drops, we have nothing to worry about. Right?
Perception is different from reality
A low VIX only illustrates the perception of safety in the market. Of course, perception is different from reality. In mid-February of 2017, one Wall Street Journal reporter remarked:
‘The last time U.S. stock market volatility started the year this low was in 2007, shortly before the subprime crisis hit. Before that, it was 1994, a year when the U.S. Federal Reserve shocked markets and hedge funds blew up.’
Simply put, expectations of low market volatility often go awry.
Why is a widespread belief that we’re in a low volatility period dangerous? Low VIX levels illustrate a cavalier attitude among investors. This boldness is often in defiance of dark economic truths.
It is an eventuality that in the long-term something will go wrong. When it does, a low VIX compounds the damage because: ‘When it goes wrong, it’s going to go spectacularly wrong because everyone’s on the same side of the trade,’ according to the founder of research firm Variant Perception Jonathan Tepper.
While a low VIX may portend danger in the future, we never know how near this future is. It may be right around the corner. Or, it may be resting below the surface for years before rearing its head.
A low VIX cannot be trusted as a sign of safety. A high VIX means it’s too late. This confusion is why it’s difficult to see a financial crisis coming.
If we can’t trust the VIX to lead our way, perhaps the analysts can help. Let’s take a closer look.
For decades, financial ‘experts’ have offered market predictions. Newspapers, social media, radio and television stream a constant orchestra of advice. Is any of it valuable? Researchers at Stanford Business School and Syracuse University have an answer.
The researchers exhaustively reviewed the forecast histories of approximately 12,000 analysts working for 600 brokerage houses. What did they find? ‘Analysts are rewarded for generating relatively optimistic forecasts.’ This finding is ‘likely due to analysts incentives rewarding optimistic forecasts presumably because they help promote stocks.’
A fundamental flaw
These findings underscore the inherent flaw with analysts. They don’t share your interests. Many of their predictions come from career aspirations rather than stock fundamentals.
The most stunning example of this flaw lies in a single statement from the multinational insurance corporation AIG. In 2007, an executive at the company discussing collateralised debt obligations (CDOs) declared: ‘It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.’
What happened next?
The CDO-triggered economic crisis brought the global finance system to its knees. The Dow Jones experienced a fall of more than 50% over the course of 17 months. This plummet presents a startling resemblance to a 54.7% drop seen during the Great Depression. The US government pledged hundreds of billions to stabilise the economy. Then US Fed Chairman Ben Bernanke warned: ‘If we don’t do this, we may not have an economy on Monday.’
Often wrong, never in doubt
The list of ‘experts’ who have failed to spot looming crises is long. In March of 2008, TV personality Jim Cramer insisted Bear Sterns was a wise stock to hold. ‘Don’t move your money from Bear, that’s just being silly’, he shouted. At the time of the broadcast, the stock was trading at $60 per share. Six days later, the shares were trading at just over $3 per share.
True, many cast Cramer aside as a showman. However, even Nobel Prize winners make disastrous calls. Paul Krugman, the 2008 recipient of the Nobel Memorial Prize in Economic Sciences, has been just as wrong. In 1998 he forecasted that ‘By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.’
Analysts of all backgrounds can be wildly wrong in their predictions. Looking at these ‘experts’ for warning signs is a dangerous game. So, what’s the solution? The answer is you.
As a self-directed investor, you’ll learn to spot the warning signs of a financial crisis. Read on, and we’ll show you how.
1.3 Learning to spot a financial crisis
If you understand liquidity, you understand how to spot a crisis. What is ‘liquidity’? When an asset can be easily bought or sold without great price fluctuation, it is liquid. As the difference between asking price and selling price grows, an asset becomes illiquid.
‘Liquidity risk’ arises when there is a lack of buyers for an asset. The risk is that the seller will become desperate and sell at any price. In such instances, the investor or institution selling may not be able to meet their debt obligations.
In short, liquidity risk is the inability to sell an asset near, or at its value. Let’s look at an example.
- 1. You must pay off $10,000 in student debt.
- 2. You find a rare coin in your attic.
- 3. Experts value the coin at $10,000.
- 4. You are having trouble finding a buyer for the coin.
- 5. Your only buyer says he’ll pay just $2,000.
- 6. Your coin is illiquid.
- 7. You’re unable to pay your debts due to liquidity risk.
Beware the bubble
What does liquidity risk have to do with spotting a crisis? Liquidity risk warns us that certain assets may not be as valuable as the market believes. Investors sell when they awaken to the hollow nature of an asset. A lack of buyers accelerates the downward movement of prices. Let’s look at a real-world example, the housing bubble.
The crisis began with irresponsible lending. Institutions extended mortgage loans to people with bad credit histories. Then, financial firms obtained the mortgages. Next, they grouped them together as the CDOs AIG claimed they were infallible. Companies sold these bundled, high-risk loans to investors. If these investment instruments were so risky why did investors buy them?
Remember the Ghost Army.
A system of deception
Companies built these CDOs upon hollow, deceptive ratings. Agencies like Moody’s and Standard & Poors issued triple-A credit ratings to these CDOs. These misleading ratings came amid a conflict of interest. The banks issuing the CDOs worked directly with the rating agencies. In short, Moody’s and Standard & Poors were on the payroll. Therefore, they felt obligated to deliver positive ratings.
In the meantime, investors were deceived with the promise of a high return amid low risk. You can hardly blame them. Interest rates were low. As a result, risk-averse investors faced few opportunities for a relatively safe return. As Buffett might say, everyone was greedy. No one was fearful.
For sale by owner
Next, housing prices dropped nationwide. This decrease exposed CDOs for what they were: risky investments built upon deception. This revelation destabilised confidence in the financial system. Trust evaporated, and lending ceased. Banks had insufficient cash on hand to meet their debt obligations. They were illiquid.
Moreover, the practice of leveraging only amplified losses. Leveraging is the strategy of borrowing cash to boost investment returns. This approach was attractive to those believing CDOs to be low-risk, high-return instruments. People thought: ‘If the risk is low and the return is high why not borrow cash to buy more? I can repay with the ample profits that are sure to come.’
The housing bubble is just one example of a financial crisis. However, it illustrates many characteristics common to widespread economic failure. In retrospect, all the clues were present.
Let’s look at the 5 major warning signs of a looming financial crisis:
1. Irresponsible borrowing and lending
Watch for increased borrowing. Problems start when crowds begin borrowing and spending more than they can afford. This capricious behaviour was the beginning of the housing bubble. Two parties were at fault. First, the borrowers should never have accepted mortgages with their poor credit histories. Second, the bankers were irresponsible in their willingness to extend loans to people who couldn’t repay them.
2. Complex investments few understand
To this day CDOs mystify many people. Investors and financiers alike were unaware of the inherent risks involved. They falsely believed that an entire housing market could falter. They were wrong. As a result, banks and investors both suffered. In the end, 60 different financial institutions were bankrupted or acquired as a direct consequence of the crisis.
3. A deceptive assessment of risk
Earlier we discussed how experts fail. Rating agencies are no less flawed. Be sure to understand who is issuing the ‘buy’ recommendation and their relationship with the asset. Wall Street is full of conflicts of interest. Keep an eye out for relationships behind the scenes. There is no analysis stronger than an unfiltered review of the fundamentals. Look at earnings, profitability, solvency and liquidity.
4. Liquidity risk
Before buying an asset, ensure you have an endgame in mind. You cannot capitalise on a gain until you sell. To sell, you must have a buyer. Sophisticated instruments present a problem because buyers are often scarce. You want to be able to move at the speed of the market. Liquidity risk hampers your ability to react. Financial crises build when the crowd want investments with high liquidity risk.
Leveraging is a powerful tool for magnifying profits. It’s also a powerful tool for magnifying losses. Personal investors should avoid this tactic unless they can absorb the full extent of the risk. Moreover, take caution as institutions like banks increase leveraging. Widespread activity like this is ultimately doomed to fail.
You cannot control the manoeuvring of central banks or brokerage firms. However, you can control how you respond.
Take a proactive stance and…
1.4 How to bulletproof your portfolio
The financial crisis is over, but history will repeat itself. Humans have succumbed to hysteria for centuries. An early example of such hysteria dates back to Europe in the early 1600s. Buying and selling activity was rampant. Prices rocketed, and some pledged their entire annual salary for a piece of the action. What were they selling?
Common tulip bulbs.
People paid fortunes for a flower. Only the spread of the bubonic plague could bring the mania to an end. Some of those paying hundreds would never live to see the bulb flower.
If you bulletproof your portfolio, it will survive long enough to bloom. In this last section, we provide an outline for taking action. When you finished reading, you’ll know how to weather the market and to avoid the noise.
Weather the market
The best offence is a good defence. As a self-directed investor, you’ll be defending yourself against the inevitable ups and downs of the market. As covered earlier, we don’t know when the market will rise and fall. For this reason, it’s best to use the strategy of…
This simple investing strategy is designed to withstand turbulent markets. Here’s how it works. You simply make a regular, fixed investment on a set schedule. For example, instead of investing your savings all at once, you invest it in pieces. You purchase a fixed dollar amount monthly.
Inevitably, changes in the share price will allow you to buy more or fewer shares each month. However, you continue to invest the same sum each month. After six months, your activity might look like this:
Month 1: $600 at $30/share = 20 shares
Month 2: $600 at $25/share = 24 shares
Month 3: $600 at $27/share = 22.2 shares
Month 4: $600 at $31/share = 19.3 shares
Month 5: $600 at $29/share = 20.6 shares
Month 6: $600 at $33/share = 18.1 shares
The idea is to spread the investment out across the highs and lows of market share prices. This range prevents the error of buying at a high point in the market. Some months, your fixed investment buys more shares. Other months, the $600 buys less.
The range of share prices creates a balance of value. However, balance isn’t just achieved with share prices. Investors must also…
Diversify asset classes
Investors have long been told to diversify. Many take this to mean they should invest in many different companies. While this is true, it’s equally important to diversify among asset classes. What are asset classes? Let’s look at a few examples:
- Real estate
When you diversify among asset classes, you are limiting risk. For example, the factors that could drive a commodity down in price are unlikely to impact equities.
An assortment of domestic and international equities is a good start. However, this strategy is not as diversified as it once was. Why? The answer is in one word: correlation.
In recent decades ‘The correlation between U.S. and international stocks has steadily risen,’ according to BlackRock. That is, there are more common factors influencing their performance. Data shows that between 1980 and 1989 the correlation was 0.47. Between 2010 and 2015 the correlation reached 0.88.
Spread your risk across uncorrelated investments with various asset classes. When you commit to this plan, you’ll weather the market and…
Avoid the noise
The investment services industry is a monolith. In 2006, the financial services sector contributed 8.3 percent to the US GDP. It continues to grow today. This growth makes for a noisy environment.
Every day, investors are bombarded with solicitations and advertisements for financial services. It’s all too easy to succumb to the distraction unless you…
Focus on the long-term
The longer you hold your investments, the better you’ll do. The recent financial crisis was frightening enough to scare many away from investing.
Retreating is a mistake.
Even though the downfall ‘knocked the stock market down almost 57%, some 91% of 401(k) investors who had account balances during the 2007-09 bear market now have more money in their accounts than they did at the market peak in October 2007,’ according to findings from the Employee Benefit Research Institute.
You have to stay in the game if you want to win.
How do you stay in the game? You only need a pencil and paper. No, really. Write down your goals. You need it in writing and tangible. In time, you’ll discover that these offers from experts don’t fit in your plan. As a result, they’re easy to ignore. Why ignore them? Because you must…
Avoid chasing returns
The hot stock of today is the loser of tomorrow. Chase the winners, and you’ll be stuck cleaning up the party you missed.
Consider a study of 3,568 funds over a ten year period ending December 31, 2013. Analysts discovered that a ‘buy-and-hold’ strategy outperformed a ‘performance-chasing’ strategy in all scenarios.
The results are consistent among small, medium and large stocks. Sticking through tough markets always wins. When times are difficult, you must hunker down and let the storm pass. If you try to fight it, you’ll get swept away.
Putting it all together
A financial crisis is difficult to spot. Market indicators often explain the present, not the future. Moreover, analysts are flawed and motivated by personal gain.
As a self-directed investor, you can watch for a looming crisis. Be vigilant of warning signs like:
- Irresponsible borrowing and lending
- Complex investments few understand
- A deceptive assessment of risk
- Liquidity risk
Remember to watch the crowds. They often foretell danger.
Protect yourself against inevitable downturns. Engage in dollar-cost averaging and asset class diversification. Ignore the hot stock tips and short-lived trends. Commit to a written long-term plan.
At the end of the war, soldiers packed up the Ghost Army. They deflated the props and shut down the artificial broadcasts. They were going home.
Follow the rules above, and you’ll be here to stay.