The stock market collapse of September 2008 through February 2009 was traumatizing for investors and for the investment industry as well. Now that there has been at least the start of a recovery, it is an appropriate time to consider the lessons which can be learned from the disaster.
Every significant downturn has its own lesson, usually related to improving how market participants understand risk. For example, the market declines of 2000 through 2001 taught valuable lessons about the nature of concentration. Investors and their advisors who thought they had achieved at least some level of diversification through investments such as Nokia, Rogers and Microsoft could reasonably have believed that at least a minimal level of diversification was created by those investments. The market collapse of the beginning of this decade showed otherwise.
Some of the striking features of the most recent collapse were its speed, broad-based nature, and depth. What this suggests is that even for investors in blue chip equities, the risk of a serious decline in market values, in the order of 40% to 60%, is much higher than was expected. To borrow language from the engineering profession, what was thought to be a once in one hundred year storm should now be treated as a storm which will arrive at unpredictable intervals every 30 or 40 years.
This insight, that the risk of very significant declines in value is a larger risk than had previously been assumed, brings with it some practical suggestions for allocations. The lesson is not that investors should avoid equities. The differences in long term returns for equities versus other types of investments remain as real as they were. However, educating clients about the risks becomes more important than ever. Further, greater care should be taken on strategies relying upon leverage and/or equity investments over a relatively short time horizon.