What does the Crisis of 2008 Teach Us on Investing?

If you want to understand the FinTech Revolution, there are two events you cannot overlook: the dot-com bubble and the crisis of 2008. I wrote about the dot-com bubble after reading Easy Money by Philip Coggan. Today, I want to share with you what I learnt about the crisis of 2008 by reading The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How To Prevent Them in the Future by John Authers.

Why you should read this book

I recommend reading more about the crisis of 2008. It helps to understand how the crisis drove to the FinTech Revolution. The Fearful Rise of Markets is one of the best books about this crisis. It presents a thorough analysis of what happened in 2007-2009 and explains all the factors that led to the crash.

Understanding the exception is also a good way to understand how things work. This book gives an overview of many features of the modern financial markets and shows the way markets operate today.

Authers’ theory: Global bubbles & synchronized meltdowns

Authers’ theory underlines that the crisis of 2008 had considerable impacts because all the world’s markets were synchronized. He explained the story of the rise of markets until 2007 and how the markets crashed together and then rebound together. At the end, you will understand what can be done to prevent another synchronized burst in the future.

Authers concludes his book writing that more stable financial markets require cultural shift. One of the key aspects is the lack of pressure on the professional investors’ shoulders. They should have incentives to manage money as if it were their own.

You will like how the book is structured. Authers introduces every chapter with an interesting quote of a famous financial figure and a topic paragraph. He ends the chapters with a summary that helps you to keep track of what you just learnt.

About John Authers

John Authers works as senior investment columnist for the Financial Times. He is well-known for writing the Short View and Long View columns, started by Philip Coggan. He is also the author of The Fearful Rise of Markets and The Victim’s Fortune.

John Authers

What I learnt reading The Fearful Rise of Markets

I want to share with you what Authers taught me through The Fearful Rise of Markets.

The Rise: Before the crisis of 2008

1. Market became tightly linked

The access of mainstream investors to every market (commodities, emerging markets…) has led to synchronized movements. As a consequence, there is nowhere to hide our savings if all the markets can crash together.

2. Investment bubbles are rooted in human psychology

Bubbles (e.g. Tulip Mania, U.S. railroad stocks, South East Bubble) and crashes are inherent to markets. They come from human needs to find patterns in the patternless market (Mandelbrot).

3. Main trends

– Principal/Agents splits: Investors tend to take more risk when manage their clients’ money.
– Herding: Investors tend to copy what their peers do.
– Safety of numbers led to overconfidence: Fund managers have the impression that the market could be controlled.
– Innovation made the exception available to everyone. Assets that where available to specialists became accessible to everyone

4. Institutionalization of investment

There are less individual investors. Mutual funds are now in charge of managing money.
– Incentives: Funds get mostly paid based on the amount of money they manage. They maximize the amount of money rather than optimize profits for clients.

– Herding avoid embarrassment: Holding the same stocks as everyone else means that if you lose money all your competitors will do the same. You clients cannot complain, if they invested in another mutual fund, they would also have lost money.

– Some mutual funds and it became difficult to hold a major part of active shares. Instead, mutual funds tend to invest in index funds.

– There is a human tendency to look at short-term performance and to expect it to continue.

5. Index funds make the market less efficient and more prone to bubble

By investing in index funds, you assume that the market is efficient. The real effect is that overvalued stocks continue to be bought as investors refer to an index and do not select the stocks in it. So prices become unrealistic because they are not correlated to the intrinsic value of companies. There is a lack of efficiency because investors make no effort to spot which stocks are over or under-valued.

“How do you beat the S&P?” he asked an interviewer rhetorically. “You beat it by overweighting some groups, underweighting others, and by owning stocks that aren’t in the S&P.”

Markets need active managers to conduct research and make sure prices are realistic.

6. Money market mutual funds made the economy more fragile

They make cheaper to finance companies but without bank deposit insurance. Money market funds are the bedrock of the shadow banking system.

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7. Oil is the new gold

8. Emerging market

The reason it is called “emerging market” underlines the importance of marketing and storytelling in Finance.

9. Junk bonds

Junk bonds are pooled risky bonds. The idea was to lower the risk with more diversification. Instead, it made the exception common and helped to finance many risky ventures.

10.Carry trade

Carry trade means borrowing in a low-interest money in order to invest abroad. E.g. borrowing Yen (Japan) to invest in Dollar (Australia).

11. Diversification

When you want to diversify your portfolio, be sure that your investments are not correlated.

12. Forex

Foreign Exchange shows how markets are interconnected. Investment funds have treated forex more and more as an investment. Keep in mind that forex investment is based on pure speculation.

13. Bubbles appear most of the time when financing is cheap

When raising money seems too easy. Cheap money and huge volume of money tend to lead to irrational exuberance.

Low rates can create a bubble (dot-com bubble). Big flow of money in a country or a mutual funds make it difficult to put it in productive investments.

14. Banks merger created problems

They become “too big to tail”. The size of banks forces governments to back them in case of breakdown. Being to big a default could lead a State’s economy to collapse.

15. Hedge funds

Hedge funds do not comply with any regulation and then cannot be advertised. As explained here, they roughly get 2% of management fees and 20% of the profits they make.

Hedge funds’ weapons:
short-selling (profiting from bearish market);
leverage (borrowing to invest). Leverage makes worth while an investment that would not otherwise be worth making trades that have a very high probability of making a small amount.

Lessons:
1. Even the best algorithms can break down (do not bet too much on it)
2. Diversification does not totally protect you (in case of a big shock, most of the markets are linked)

16. Commodities

The idea of investing in commodities was based on diversification. But it made them correlated to stocks.

According to Jim Rogers, a commodities trader, commodities experience longer bull cycles than stocks.

17. Credit

– Credit derivates let people believe that banks were able to control risk. Instead, it spread risk all over the markets.
– CDS is a form of insurance against default. It enables to swap exposure on another institution.

Indeed, insured risk enabled banks to take higher risk on mortgages and corporate loans. Banks thought that they were protected thanks to diversification and the high number of loans (safety in numbers).

The innovation came because it was possible to buy cheap (same for BRICs and commodities boom). Cheap money through credit led companies to buy up their own shares and private equity funds to do LBOs.

“Credit default swaps started as a risk management tool but enabled the systemic underpricing of credit. This made financing cheaper and pushed up prices of assets across the world.” At the beginning, CDS were used as a way to manage exception. Quickly, the exception became the norm. And the crash arrived.

> The Fall: The crisis of 2008

This part underlines some useful things we can learn from a crisis. These patterns are likely to happen during another crisis.

1. Bubbles require steady increase and low interest rates. These circumstances make investors think that they can predict the future. But the market is unpredictable.

2. Markets’ daily movements reflect mass psychology more than the economy.

3. Periods of moderation allowed lenders to offer excessive credit which made credit too cheap until the cumulative excesses caused a speculative collapse.
According to Minsky: “Long period of low volatility drives higher volatility”.

4. Quantitative models brought many investors into the same investments but they did not model the effects that such crowding would have.

5. Bubbles burst because markets are overvalued. Yet, this implies that the assets in the bubble are overvalued with respect to something else. Before the crisis of 2008, everything was overvalued.

6. Diversification itself is as good idea. You should not put all your eggs in one basket. But in a globalized world you can put your egg into different markets and find out that they are still in the same basket.

7. Equities beat bonds over the very long run. However, there are long periods where bonds can beat equities. It is false to think that equities always protect from inflation risk.

8. Modern diversification = allocating according to risks not asset classes

> The Fearful Rise: After the crisis of 2008

The fearful rise points out that the 2008 crisis was almost unique in the way markets recovered. This happened rather quickly because central banks and politicians decided to support the economy.

1. Emerging markets proved to be stronger than during previous crisis.

2. Crisis leads insolvent firms to fail. Once investors are confident that no other big firms will fail, they start investing again.

3. When investors feel heavily bearish, a minor piece of news can change their mind.

4. Central banks have a big influence on how confident are investors. And it can push them to take risk by reducing interest rates near to zero.

5. A relief-rally is to be expected after a big sell-off.

6. The quick recovery after the crisis seems to be built on another bubble.

7. The future of investment includes ETFs, which have became popular since 2009.

8. Politicians chose to encourage risk taking at the cost of an unhealthy recovery. The danger is now that another more severe financial dislocation will be needed finally to purge the markets of these distortions.

9. Because states borrowed a lot of money and the reasons that led to the crisis have not been cured, the next crash can be profoundly worse.

Conclusion & take away

The Fearful Rise of Markets is a great book that drives you into the whole story of one of the most terrible economic crisis. It is simple to understand and well written.

Read it and you will understand how modern finance works.

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