Lessons from the Great Financial Crisis

After the financial crisis that shook the markets a little over ten years ago, investors seem to be restless and cautious, considering that markets tend to behave cyclically.

For a couple of years, headlines of various financial publications have showboated that a market correction is near, imminent and will have strong magnitudes. There are professionals who have focused their research on financial bubbles and market crashes, and are actively looking for analogies with current market conditions, so that they will eventually be recognized as the oracles.

Phillip Tetlock, in his book “Superforecasting: The Art ans Science of Prediction”, comments on the qualities of a good forecaster, and points out the importance of the time horizon, someone that is right on its forecast but fails on the time frame can be considered as wrong.

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The built up anxiety in many investors can be justified by the markets’ strong rebound. The Dow Jones index has advanced 292 percent from its March 2009 lows; however, some argue that, by definition, the rally started as of the first quarter of 2013, when the previous highs were exceeded. From those levels the Dow has shown an 82 percent rise, edging above the 25,380 mark on November 2018. In annualized terms, these hikes translate into 14.9 and 11.1% compound annual growth rates.

Although these advances, even measured in annualized growths, seem to be stretched against the long-term rhythms (6.6 and 5.7% per year compounded in 50 and 100 years’ horizons for the Dow, respectively), we can conclude that the factor that makes them reach the double digit is the speed of the recovery.

During the Great Depression, it took fairly 99 quarters for the Dow Industrial to surpass its previous high; whilst in 2008 previous highs were recovered after barely 21 quarters. Someone could assume that a more mature market with a larger number of participants, combined with coordinated global monetary policies, led to a faster recovery.

Now, with no eagerness to predict the next big adjustment, it is always worth having a flight plan. If the markets were to witness a correction tomorrow, in two, five or ten years, how should we react?

It is important to consider both my risk profile and that of my investment. Despite having a high-risk tolerance, if my investment horizon is short, my reaction should differ when compared to someone with a larger horizon. Likewise, my investment style is another relevant factor. If I am an active trader with a proper liquidity and risk management, my tactics will vary to those of a passive investor.

Assuming a passive strategy with a long-term horizon, let’s see how four scenarios would have resulted: a) maintaining your position, b) maintaining your investment rhythm, c) maintaining your position and contributing, but not investing, and d) maintaining position and continuing to contribute but investing until recovering previous highs.

The first scenario considers a $50,000 investment by the end of September 2007, at the end of August 2017 it would accumulate a 57.9% profit, reaching $78,900,  and would have recovered its investment by February 2013.

The second scenario, known as Dollar Cost Averaging (DCA) was to start with $50,000 invested in the Dow Index, and to add $1,000 monthly investments in the same index. Under this strategy, the amount invested reached positive ground since February 2011, two years before scenario “A”. Keeping up with this DCA, would have translated into an effective return on total investment of 63.4%, enhancing $170 thousand into almost $278 thousand.

The “C” scenario contemplates that the initial investment will be maintained, and the contributions will not enter the market and will be held in cash — here we assumed a 0% return on cash as rates abruptly plummeted during the crisis’ aftermath. In this case, the investment exceeds what was contributed by February 2013, just like the “A” case, but the actual return is only 17% — on the back of opportunity cost — with a final balance of $199 thousand where $120 thousand stand as cash.

Finally, we assume a hybrid scenario, where we maintain our position, continue to contribute, but we invest in the Dow until it recovers its previous highs. That is, as in case “C” but in February 2013 we the market with our outstanding cash, and continue to contribute as in the DCA, in this scenario the effective return is 47.2% accumulating just over $250 thousand compared to a total contribution of $170 thousand.

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