There are many lessons that investors can takeaway from the current financial and market crisis. Recently I wrote an article that covered the need to always understand the various risks that are present in our portfolios. This is something that American International Group (AIG) neglected to do on their own balance sheet, and this oversight led the company to the brink of bankruptcy. The original article is below and a  version that appeared in Ontario Dentist is available for download below.

 

Market Turbulence – A Lesson Learned

 

If you recall, back in June I asked whether you thought the bull market in commodities would continue unabated, and I’m sure many of you thought that indeed it would. Oil was climbing towards $140 USD a barrel and their seemed to be nothing stopping its hockey stick shaped increase. Now I wonder if you think oil will even trade above $100 in the next 12 months. We as humans suffer from a recency bias, which means that we project current market conditions much too far into the future and forget about long-term market trends and cycles. We observe the most recent pattern and extrapolate it into being a new long-term trend. Presently we’re experiencing a major selloff in the world’s financial markets and I’m sure many of you have a pessimistic view that the markets will continue to fall or trade sideways for a very, very long time. While I cannot predict if the global financial markets will correct themselves over the next 1-3 months, I am confident that over the next 1-3 years the system will have washed itself out and we will look back on this crisis as just one of many that we had to endure as investors in a capitalist economy.  Many of you cannot envision these greener financial pastures, but they will return, and when things begin to go well again in the market, your recency bias will cause you to forget a valuable lesson we can learn from the present market crisis. So please file this article away and reference it again once the markets have recovered and you feel like the markets will only ever go up, up and up again.

 

So what is the key lesson that I would like you to remember in the next boom time? Let me explain using the recent market example of American Insurance Group (AIG). The principal reason that the world’s largest insurance company, AIG, recently found itself on the brink of bankruptcy was that it didn’t understand the risks that it was taking on its own balance sheet. AIG underwrote a huge number of derivative contracts, called credit default swaps (CDS), which work like insurance in that they guarantee against a company failing to pay back their debts. If I was concerned that Wal-Mart might go bankrupt, I could purchase a CDS to cover any investments I might have made in Wal-Mart bond. AIG’s CDS contracts insured a whopping $441 billion of fixed income investments, including $57.8 billion in securities tied to subprime mortgages. What is the lesson learned here? Well in boom times these CDS contracts were highly profitable for AIG, but when the good times ended, having a balance sheet with a large number of complex, high-risk financial products on it, spelled financial ruin. So my question to you is: Do you or your advisor completely understand all of the securities that you’re invested in? If not, how can you be certain that they’re:

 

a) appropriately matched to your investment goals,

b) not liable to self-destruct and

c) will recover along with the markets in the future?

 

You or your advisor must absolutely understand the risk/return relation that each and every investment opportunity presents you. Earning a huge return on your investments is great, but if you don’t understand the underlying risk of those investments, you could be setting your portfolio up for economic disaster a la AIG.

 

The list of complicated products that are sold to individual investors each and every day is extensive and includes: hedge funds, principle protected notes, exchange traded notes, index-linked GICs, flow through shares, labour sponsored funds and guaranteed minimum withdrawal benefit annuities. If you have the time, I would encourage you to either read the prospectus or information statement that should accompany the above investments or have your advisor fully explain all the associated risks. I would also encourage you to inquire how your advisor is compensated by the products he sells you. Some products, notably hedge funds, do not have to make any type of information disclosures to you. To me this should be an immediate red flag. Your being marketed a product most likely because of its previous historical returns. Remember AIG above and how beneficial it was to make a great return when you don’t understand the associated risks. If you presently hold some of these products I’ve mentioned and are unsure of their risks, seek out the guidance of someone who can explain them to you and make an objective recommendation about their suitability to you and your investment goals.

 

 

 

Article as it appeared in the December 2008 issue of Ontario Dentist.