The final analysis What helped amplify the world financial crisis is that everyone took on too much risk. Diversification is your most important weapon against surprise, but don't use it blindly.
Lessons to be learned from our years of living dangerously
One of the bottom-line conclusions about what helped amplify the world financial crisis is that everyone took on too much risk. That includes governments, corporations, investment managers and individuals. That risk was increased because of faulty financial models and excess leverage - the use of too much borrowed money in an attempt to maximise returns. Government enforcement of existing financial regulations was lax, and in some cases governments loosened laws designed to protect investors and the financial system.
If you borrowed too much on your credit cards, or took out a large personal loan, or bought too many commercial or residential properties off-plan, or assumed your job, bonuses, and revenue growth would go on forever, then you know what I'm talking about and are probably feeling the pain. What might we learn from the crisis that could help our own personal investment decisions? First, we must assess our strategy and the impact it has had on our portfolios over the past couple of years. What could we have done differently, assuming we do not know what's going to happen in the future? How can you take some of those lessons and implement them now?
Feeling a degree of certainty about where the economy, stocks or other types of investments are heading is not the way to success, as the future is inherently uncertain and will remain so. Individual investors have a tendency to grab hold of a forecast and use it to justify their decision, because it makes them feel comfortable. If they feel a degree of uncertainty is alleviated, they receive a sense of comfort. But agreeing with a particular forecast or belief about the future does not diminish risk in any way. On the contrary, doing so often makes us blind to new information that would likely show us that our assessment was wrong.
The truth is that no one knows what the economy is going to do; it is all informed (or, in some cases, uninformed) prognostication. Rather, we should assume we are wrong until proven otherwise and let that guide our investment decisions, always being prepared for the worst. Newspapers, magazines and the internet are overflowing at this time - the early stages of a new year - with forecasts for currencies, markets, economies, companies, commodities and property.
It's no wonder investors are confused: the experts almost never agree, and even when they do, the chance of something different happening is still very high. Of course, predicting future prices is inherently risky and difficult, because the outcome depends solely on the assumptions used. If there is anything off in the assumptions, or if any surprises appear, the forecast will be wrong. And one thing that I always keep in mind, and hope you do, is that there are almost always surprises.
Diversification is your most important weapon against surprise. A common mix of financial assets might be 50 per cent in bonds, 40 per cent in equities and 10 per cent in commodities; bonds are considered lower-risk investments, and equities and commodities come with higher risks. Returns would come from the riskier asset classes, while the bonds would provide stability. The specific components in each of these asset-allocation categories are then determined by an investor's particular objectives and risk-comfort level. Many diversified investors, however, have recently realised that their returns did not compensate for the actual risk in their portfolios. The recent financial crisis made a mockery of correlation models, as positions that were supposed to go up, balancing poorly performing assets, went the opposite way.
Nassim Taleb, a portfolio manager and author of the book The Black Swan, has proposed a slightly different approach. He suggests that investors would be better off building portfolios that contained 90 per cent treasury bills from multiple countries, and "swinging for the fences" with the remainder, taking as much risk as desired. If his approach works out, the high-risk investments would provide large returns to compensate for the negative returns of losing positions and the low returns of safe treasuries.
Diversification is fine, but don't use it blindly. Bruce Powers is a financial consultant, trader and educator based in Dubai. Write him at email@example.com