When thinking back on the most recent global meltdown, two quotes come to mind: “What doesn’t kill us makes us stronger” and “Those who cannot remember the past are doomed to repeat it.”
We at T. Rowe Price remember all too well the volatile financial markets of the past and have distilled some lessons from them for companies and individuals as we recover from the worst financial market crisis since the Great Depression.
1. Watch Your Liquidity. Don’t fund long-term
assets with short-term liabilities. In the midst of last year’s crisis, the commercial paper and other short-term markets ground to a standstill. This posed a dilemma for companies that did not have enough cash on hand to finance their daily operations. Companies should always ask themselves how they would stay in business when they can’t borrow money from traditional sources.
2. Balance Sheet Strength Matters. Always be aware of your overall debt load and have a prudent appetite for leverage. While leverage enhances returns in a booming market, it causes problems when markets turn against us. Keep an eye on your corporate and household balance sheets and don’t get overextended.
3. We Are All Connected. No company or individual is an island in the global economy. We can’t disassociate ourselves from what is happening elsewhere since globalization has linked us all in an intricate network of financial transactions. When the U.S. catches a cold, smaller economies in the world are likely to come down with pneumonia.
4. Financial Innovation Helps Wall Street, Not Main Street. Innovation is a good thing, but too much of a good thing can prove disastrous. In recent years, Wall Street has developed financial instruments that were so exotic that not even their creators fully understood them.
Wall Street issued debt, repackaged it, then repackaged the repackaged debt. The Street developed a litany of acronyms to make them more palatable to the investing public—ABS, ARMs, CMOs, REMICs, and PIPEs. These acronyms only served to camouflage the instruments’ complexity and risks.
5. Get a Map of Washington, D.C. Whether we like it or not, the U.S. federal government is going to become more and more involved in the financial services industry.
We are embarking on an era of greater government involvement and regulation. While we welcome transparency and laws designed to protect people against fraud, it would be counterproductive for the regulators to tell well-run companies how to manage their businesses.
6. Simplicity Is a Virtue. The financial meltdown has brought most of us back to our senses. We are rediscovering the old virtues about how to properly finance our purchases - how to buy our homes and cars, how to manage our households. We are learning once again to live within our means and not to adopt lifestyles we can‘t afford.
7. If It Sounds Too Good to Be True… Well, it most surely is. If someone claims that he or she can generate outsized gains without a corresponding level of risk, get a firm grip on your wallet and chequebook. Returns in excess of historical norms are virtually impossible to sustain for long periods.
8. Don’t Search for Yield in Money Market Funds. Some money market funds, which are among the most stable of investment vehicles, got into a lot of trouble last year by lowering their standards in an effort to generate higher yields.
Their managers included securities in their portfolios that didn’t belong there and, as a result, put their investors’ principal at risk. Money funds were designed to be ultra-conservative and satisfy the cash needs of their shareholders. These funds did their shareholders no favours by investing in less than the highest-quality securities.
9. The World Doesn’t End That Often. In the midst of the latest financial crisis, it can appear as though the world as we know it is coming to an end. If this were true, however, civilization would have disappeared centuries ago.
In the last century alone, we endured World War I, World War II, the Korean War, Vietnam, Watergate, the savings and loan implosion, the Argentine peso crisis, the Russian ruble crisis, and dozens of other world-shattering events. Each time the human race has managed not only to survive, but also to go on and prosper even more.
Had we put our investment capital under the mattress each time a crisis reared its ugly head, we would never have benefited from the market rebounds that followed. Each time a bubble bursts, it is critical to remember: “This, too, shall pass.”
10. We Will Have Other Crises. There is another bubble waiting for us somewhere down the road. We don’t know what it will be and when it will burst, but we all need to be aware that bubbles do not continue to expand indefinitely.
We need to take measures now to protect ourselves against the next tumultuous financial cycle. We do this by not overextending ourselves financially, remaining well diversified, keeping our own tolerance for risk at the forefront of our investment decisions, and establishing a long-term investment strategy that makes sense to us in all market environments.
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