Concentrate the Mind

28 October 2008 Jason Butler APFS, CFP, IMC

Jason Butler of Bloomsbury Financial Planning explains how keeping a clear view will help avoid panic about the current global downturn.

Stock markets around the world fell sharply on Monday 15 September following Lehman Brothers' bankruptcy announcement. Credit-related worries caused a number of other financial firms’ shares to sink sharply as well: AIG fell 60.8%, Washington Mutual was down 26.7%, and Citigroup lost 15.1%. Among the 30 Dow Industrial component issues, only Coca-Cola managed to eke out a gain, closing up 25 cents for the day.

The FTSE 100® Index fell 3.92%, its largest one-day percentage loss since 21 January 2008 when the Index fell 5.48%. Ranked by magnitude of one-day losses for the FTSE 100® Index, Monday's decline ranks 16th among all trading sessions since May 1984. Although some market breaks are still fixed in our memory, others have faded from view. Few private investors can recall what the news background was when stock prices plunged on 15 July 2002; 12 March 2003; or 22 March 2001.

"The last few weeks have highlighted the importance of diversification and investing in the context of one's risk capacity and personal goals."

Financial journalists will undoubtedly be scribbling energetically in the coming weeks to offer anxious investors an explanation for ‘what it all means’. A sample appears in a recent issue of Forbes, where three prominent investment professionals offer their views of the future: one is quite bullish, one is quite bearish, and the third is cautious but hopeful. Each offers compelling evidence to make their case. The only investors likely to improve their portfolio results by reading such observations are those who were not properly diversified to begin with and become motivated to take action. The world is an uncertain place, and sharp fluctuations in asset prices reflect that uncertainty.

There is ample historical evidence that market economies are resilient. Without Lehman Brothers advice or residential mortgages from Fannie Mae, the world will still get along and manage its financial affairs just as well. The message for investors is to avoid their financial future getting derailed by events at a small number of financial firms. Investors must ensure that their portfolios are properly structured to capture all the returns that markets can offer when, and it is when, the next market recovery starts. The last few weeks have highlighted the importance of diversification and investing in the context of one’s risk capacity and personal goals.

In a matter of days, shareholders of three financial giants—Fannie Mae, Freddie Mac, and Lehman Brothers Holdings—have seen their shares plunge into the penny-stock category. A fourth, American International Group, has been effectively nationalised and shareholders diluted to a very small minority interest. For well-diversified investors, the financial damage associated with these four firms has been minor; in aggregate, they represented less than 0.25% of a diversified global portfolio on 31 May 2008. In five or six years’ time investors may have a difficult time remembering what happened and when.

However, for those with concentrated positions, especially employees with large holdings of company stock, these events are a financial tornado inflicting potentially irreparable damage. One business owner cited by the Wall Street Journal recently purchased 25,000 shares of Freddie Mac at roughly $5 and lost most of his investment in a matter of days. Ironically, he claimed to be through with day-trading strategies, and was seeking a profitable long-term investment.

Elsewhere, the Wall Street Journal estimated that the 24,000 employees of Lehman Brothers have seen $10bn in personal wealth evaporate as the value of Lehman shares collapsed. Many long-time employees of Fannie Mae or Freddie Mac have experienced similarly catastrophic losses. When times are good, the risk of a concentrated portfolio often appears extremely remote. Unbelievable as it may seem now, Fannie Mae was once characterised by the US Money magazine as "America's safest stock", with a bulletproof business model that was "as close as you'll get to an invincible earnings machine".

Events of 2008 demonstrate the importance of getting a few big issues right. All the debates about quarterly Vs annual rebalancing or whether to allocate 25% or 30% to foreign shares appear almost ridiculously pedantic in the face of such overwhelming but avoidable losses.