A year after the low point of one of the worst bear markets most investors have seen in their lifetimes, you might be tempted to dismiss the entire financial crisis as a fluke. If you don't remember the lessons that the market meltdown taught you, however, then you'll be doomed to repeat the mistakes you made the next time something goes wrong in the financial markets.
The experience you paid for
During 2008 and early 2009, investors found themselves in an extremely tough investing environment. It was hard to find anything that would protect your assets, as it seemed that stocks, bonds, commodities, and real estate were all vulnerable to the effects of the economic recession.
In that context, Seth Klarman, who heads up the Baupost Group investment partnership, recently shared 20 important investment lessons from his experience of 2008. You can read them all here, but I wanted to touch on four that are particularly important for investors at all levels.
"Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return."
This lesson is a variant of Warren Buffett's admonition to be fearful when others are greedy. As a perfect example, many experts believed that oil's move to nearly $150 per barrel in mid-2008 was the result of unsustainable speculation. Similar moves in other commodity-related markets also appeared ripe for reversals.
Yet that didn't stop many investors from jumping on the commodities bandwagon right up to the bitter end. Even Buffett fell prey to the allure of the energy sector, making an ill-advised purchase of ConocoPhillips (NYSE: COP) shares. Paying top dollar for stocks like PotashCorp (NYSE: POT) and Chesapeake Energy (NYSE: CHK) was dumb in hindsight, but many such companies had seen strong gains continue far longer than seemed likely. If you sold early, you missed some gains -- but you also avoided big losses that more than made up for them.
"Risk is not inherent in an investment; it is always relative to the price paid."
Many investors find it impossible to wrap their heads around the idea that risk is proportional to price. They'd argue that when Sirius XM Radio (Nasdaq: SIRI) was trading for a dime and you could buy Ford Motor (NYSE: F) shares for less than $2, it's because the risk of their failure was highest.
However, ultracheap valuations proved to be the seed for amazing gains during the ensuing rally. Clearly, it made more sense to invest in companies costing pennies on the dollar compared to what shares would have cost just months earlier. Even if you lost everything, it would have been far less than what longer-term investors had already lost -- and the potential gains were stellar, as the rally proved.
"The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance."
The importance of intrinsic value is magnified during volatile markets. If you don't have an independent sense of what a stock is worth, then market movements can force you to second-guess your investing decisions. Although economic conditions can have an impact on intrinsic value, it's nearly inconceivable that the true value of huge companies like Microsoft (Nasdaq: MSFT) and Kimberly-Clark (NYSE: KMB) can fall 25%-50% in a year's time -- and then bounce back to their original values the following year. Yet that's exactly what the stock market does all the time.
Finally, here's something Klarman characterizes as a false lesson:
"Bad things happen, but really bad things do not. Do buy the dips, especially the lowest quality securities when they come under pressure, because declines will quickly be reversed."
Once again, 2008's bear market provided an example of just how quickly stocks can rebound from setbacks. Yet to conclude that they'll always do so is to create a false sense of security. Stocks could easily head back downward, especially if the economy fails to respond to all the dramatic measures that the government has taken to shore up the financial system.
Remember
Things may look good now, but investors should never think that they're immune to risk. If you've decided that the all-clear has sounded, you still need to remember what the bear market taught you. That way, you can protect yourself from a potential relapse down the road.
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