While the dust has not yet settled on the Bear Stearns situation, the crisis provides us with an opportunity to review some of the principles of prudent investing. These principles have stood the test of time. And in the case of the latest crisis, they protected investors who followed them from experiencing catastrophic losses.
1. Liquidity is king.
There is an old adage on Wall Street that "liquidity can be an illusion - it is there when you don't need it and can disappear when you do." While Lehman Brothers apparently learned that lesson in 1998 (and did not make the same mistakes this time around), Bear Stearns did not. They did not line up sufficient liquidity to withstand a crisis - a run on their liquidity. Two issues exacerbated the problem. The first was that the securities that Bear Stearns had its capital tied up in were risky assets. In a liquidity crisis, the markets for such assets can literally disappear (there is virtually no bid). Had most of their assets been of greater credit quality, the problem would not have been as severe. The second problem was that the firm was highly leveraged, much more so than the other major investment banks. And when you are highly leveraged you have to be right all the time (because while you might be right in the long run, in the short run you can die, as Long Term Capital Management found out). This is one of the many reasons that we do not recommend hedge funds (many of them employ large amounts of leverage). And given the amount of leverage employed by Bear Stearns, they might have been considered not much more than a big hedge fund that happened to provide other financial services. One lesson for investors is that they should always have a sufficient amount of "emergency" reserves (a typical recommendation is to hold at least six months' spending requirements) in the form of short-term instruments of the highest credit quality so that they do not have to sell risky assets during a period of financial stress. And finally, if you know you will definitely need cash to meet a known obligation, that amount of funds should be invested only in instruments that have guaranteed liquidity (e.g., Treasury instruments).
2. High-yielding assets are risky, and it is likely that eventually the risks will show up.
We just don't know when it will happen, what might be the trigger, how deep the crisis will be or how long it will last. Those are all unknowable. Thus, the main role of fixed-income assets in portfolios should be to reduce the overall level of risk of the portfolio to an acceptable level, allowing the investor to hold the amount of equities that is appropriate given their own unique ability, willingness and need to take risk. Therefore, fixed-income instruments should be limited to only those of the highest investment grade. Those investors that followed that principle have basically avoided the problems of not only the subprime mortgage market, but also the junk bond market and the municipal bond market as well. Another important lesson is that equity investors could have diversified away much of the risks of investing in the equity of Bear Stearns, but investors in risky fixed-income assets suffered no matter how many different securities they owned because of the liquidity crisis.
3. Credit enhancement is nice, but not sufficient.
Because the main role of fixed-income assets in a portfolio is to reduce overall portfolio risk to an acceptable level, it is important to maintain the highest credit standards. That is why one of the principles of prudent investing for municipal bond buyers is to look through the credit rating of an insured bond and make sure that on a stand-alone basis the credit risk is acceptable. It is important to understand that municipal bonds are far less likely to default than a similarly-rated corporate bond. In fact, a single A-rated municipal bond is about 90 percent less likely to default than a single-A-rated corporate bond. Similarly an AAA-rated municipal is less likely to default than an AAA-rated corporate. Thus, a municipal bond that is AAA-rated because its credit has been enhanced by a corporate guarantee is not as safe as an AAA-rated municipal bond that does not require the guarantee of an insurer. The market knows that. Yields on insured bonds are higher than on similarly rated uninsured bonds. Investors should set high standards for the underlying ratings and not try to chase a few extra basis points in yield by purchasing bonds that rely on the credit enhancement to get a rating that passes the credit standard set by the investor in their investment policy statement.
4. Unlikely is not impossible.
Bear Stearns made this common error in more than one way. First, it certainly was not impossible that a severe liquidity crisis would develop. Second, their big bet on subprime mortgages depended on housing prices not falling to any significant degree. This had occurred in the 1980s when energy prices collapsed and home prices fell in the oil belt. Just as is occurring today, homeowners were mailing in their keys to their mortgagor. In addition, today's subprime mortgages had much more lenient terms (less equity required) than was the case in prior periods - making them more risky. And, while we had not experienced a nationwide fall in home prices of any degree since the Great Depression, that did not mean that we could not experience one. In fact, one of the more common errors investors make is to fail to understand that just because something has never happened does not mean it cannot happen (consider the events of September 2001). Thus, one of the most important principles of prudent investing is to never treat the unlikely as impossible and to also not treat the likely as if it is certain.
5. In a crisis, the correlation of equity asset classes tends to rise.
Broad global diversification across many equity asset classes, including those with low correlation to other portfolio assets, is one of the principles of prudent investing. However, investors also must understand that, in times of financial crisis, correlations among equity asset classes (and all risky assets such as junk bonds) tend to rise. Evidence of this is how quickly the subprime crisis spread around the globe, impacting all equity asset classes (and all risky bond classes as well). Even with a significant tailwind of rising currency values, international equities fell. In this crisis, the only safe harbor (besides commodities) was the highest-quality fixed-income instruments. That is why it is important that the portfolio have sufficient high-quality fixed-income assets to ensure that overall portfolio risk is at the appropriate level.
6. Active management won't protect you.
Whenever there is a situation like an Enron or a Bear Stearns, you will hear about the need for active management to protect you from such "obvious" situations. Nothing could be further from the truth. First, index funds simply own the market cap weighting of all stocks within the index. That means that in aggregate, active investors also own the same proportional share of any given stock. A good example of the failure of active management to protect you is that Bear Stearns was one of the largest holdings of the Legg Mason Value Trust that is managed by legendary investor Bill Miller. Miller had beaten the market 15 years in a row. However, that streak was broken in 2006 when Miller underperformed the S&P by about 10 percent. His 2007 performance was even worse. And in just the first three months of 2008, his fund is underperforming the S&P 500 by a wide margin once again - with Bear Stearns contributing to the underperformance.
7. Hedge funds won't protect you either.
Some of the largest losses were experienced by hedge funds, including two run by Bear Stearns. One of the problems with hedge funds is that their risks often highly correlate with the risks of equities at the worst of times, during crisis. So just when you need the low correlation that they advertise as a benefit, the correlations rise. That is just one of the many reasons you should avoid investing in hedge funds. What hedge funds are effective at is transferring assets from the country club set to investment bankers.
8. Don't confuse the familiar with the safe and end up having too many eggs in one basket.
For the 20-year period ending in 2006, Bear Stearns' stock outperformed Berkshire Hathaway's stock by an amazing 4.5 percent per annum. With returns like that, who needs Warren Buffett? And consider the following story that appeared in Barron's in 2004. The author noted that "with the company's low risk profile and strong controls, investors in Bear Stearns can sleep well, knowing that even a full-blown financial crisis is unlikely to cripple the firm."1 In January 2007, the stock hit an all-time high of $171. We can only wonder how many employees of Bear Stearns had significant portions of their net worth tied up in company stock because they "knew" what a great company it was. And surely they would know if there were problems arising and have sufficient time to exit. It is safe to assume that those same employees would not have invested in Bear Stearns stocks if they were employed elsewhere. Bear Stearns was not any safer because the individuals happened to work there. Yet, employees seem to make that common error because they confuse the familiar with the safe. And for senior management, they may even have an illusion of the ability to control events. The prudent strategy is to diversify all of your assets. And that includes your labor capital, not just your financial assets. And while the surest way to get rich is to concentrate your assets, it is also the surest way to go broke. While investors who had concentrated positions in Bear Stearns suffered greatly, investors that owned market-like global portfolios had a small fraction of 1 percent of their assets in Bear Stearns stock, even when it traded at its peak. This is a clear demonstration of the importance of diversifying equity risks. Unfortunately, as sure as death and taxes, despite the lesson Bear Stearns provided, this same mistake will be repeated many times over by future investors.
While each crisis the markets face is in different in some way, those that follow the principles of prudent investing can minimize the risks of catastrophic losses. Those rules include:
- Avoiding taking more risk than one has the ability, willingness and need to take by ensuring that you have sufficient fixed-income assets.
- Limiting the fixed-income portion of the portfolio to the highest investment-grade securities.
- Ensuring that you maintain sufficient liquidity so that you are not forced to sell risky assets into an illiquid market.
- Avoiding confusing the familiar with the safe.
- Never mistaking the unlikely for the impossible and the likely for the certain.
- Avoiding having too many eggs in one basket, especially if that basket includes your labor capital.
The bottom line is that those investors that follow these rules, and build financial crisis into their plans by anticipating them, are far more likely to survive them in good shape.
1 Andrew Bary, "How Sweet It Is," Barron's, August 2, 2004.
Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn't Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You'll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services - a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices - in Clayton, Missouri (www.bamservices.com).
His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.