Last month apparently represented the twentieth anniversary of the start of the Asian crisis, and five years since Draghi’s ‘whatever it takes’ speech. This week apparently marks the ten-year anniversary of the financial crisis.
These events make great ‘hooks’ for content in the press, blogs, research notes and the like – especially in the quiet summer period.
They appeal to our human need to impose order on the past by creating stories. The present always seems chaotic and uncertain but we can comfort ourselves by making the past seem orderly. By creating timelines of the events that led to the financial crisis we can create a sense of inevitability. By wheeling out those who predicted the crisis we can comfort ourselves that ‘if only I had known x and y’ I could have seen it coming, and we become beguiled into thinking the crisis was inevitable all along.
However, this can be dangerous. In reality we can only say that July 2007 marked the beginning of the crisis with hindsight. Markets – which are characterised as either highly efficient information processing mechanisms, or basket cases of human emotion depending on who you ask (and when) – did not react in earnest until sometime later.
Even in credit and interbank lending markets, the extent of the problems would take some time to emerge.
When we look at history, we are inclined to think in terms of a ‘chain reaction’ of events; it becomes tempting to believe that, once July 2007 had happened, there was no other course of events that could have taken place.
When we look forward however, we have to deal with probabilities:
“More things can happen than will happen”
– Elroy Dimson
Experience suggests that more forecasts of an impending crisis turn out to be wrong than right (or at least take so long to become ‘true’ that it ends up being very expensive to wait). Even when we are presented after the event by a selection of those experts that ‘called the crash’ how do we lesser mortals know which one to trust next time around?
Beyond the Philosophy
This may seem very abstract, but it is a vital consideration for investors. It is dangerous to believe that we could have known how the future would pan out because it pushes us further toward over-confidence – which is arguably the biggest risk that investors face.
Forensically examining the past for possible lessons can be useful, but it can also be damaging. The belief that ‘if I had only done that extra bit of research I could have avoided the crisis’ can lead to a belief that the research we have done today is sufficient, particularly if we use a model from the past to analyse the future. This in turn blinds us to the true range of possible outcomes that are out there.
It is far more important that investors are humble and acknowledge their own ignorance. This does not mean that we need to blunder aimlessly into crises, but rather that we always acknowledge that such events are part of the probability distribution and seek appropriate compensation for that risk.
This compensation for risk is critical; while deeply damaging, the financial crisis did take place from a relatively attractive starting point of valuations. As CNBC’s Michael Santoli noted yesterday, in the ten years since the crisis started the S&P 500 has delivered an annualised return of just under 10%. This doesn’t even account for the investment opportunities that are often created in the aftermath of a crisis.
The chart below shows that while the financial crisis resulted in a devastating five years wait to get your money back, the comparison with the tech bubble is telling. In that case, there was no compensation for risk, and as a result it took nearly seven years to break even – by which time, even those who had invested at the pre-financial crisis peak in 2007 had generated a 4.8% annualised return.
The biggest lesson we can learn from the past is how deeply chaotic it is, and how little we can truly know about what is going to happen. Our tendency to create order out of history by telling stories about anniversaries and timelines generally tend to have the opposite effect.