Top ten lessons from the financial crisis [23/01/2010]
Top ten lessons from the financial crisis
Three months into 2009 it seemed another annus horribilis was upon us; March saw the FTSE100 hit 3,500 (a 6 year low). Nine months on, however, the risk of financial Armageddon feels small, stock markets have bounced back and the UK has taken its first steps on the long road to recovery.
1. Don’t borrow more than you can afford to repayThe housing boom of the last decade was fuelled by a classic bubble of over-confident investors and easy credit from greedy lenders. A new generation, who had never experienced a fall in house prices, borrowed too much and treated their homes like a cash machine. The aftershock of the crash has been limited by the lowest interest rates in 300 years.
2. Your cash may be at riskNot long ago it was almost impossible to imagine that a UK bank might go bust. The Financial Services Compensation Scheme (FSCS) limit, then £33,000, was almost an after thought and no one talked of cash savings being at risk. The failure of Northern Rock and the Icelandic banks means savers are now as concerned about safety as they are about the rate of return. Many choose to restrict their savings to the new FSCS limit of £50,000 per institution or use Government-backed products from National Savings & Investments.
3. It’s important to have an emergency fundA cash cushion is fundamental in any financial plan, yet many ignore this during booms, relying on credit cards, overdrafts or future pay and bonuses to tide them over. An emergency fund of 3 to 6 months expenditure in an instant access account is vital to cover the unexpected, such as health problems or redundancy, and provides greater financial security.
4. Diversify your portfolioThose who were over-exposed to certain assets or holdings (e.g. property or banking shares) were hit the hardest, as were employees with large shareholdings in their employer’s company. The old adage of not holding all your eggs in one basket has proven itself once again to be sound advice.
5. Understand your investmentsMany investors didn’t truly understand the risks of structured products, they liked what they were offering but had no idea how it was being provided; they didn’t know they were backed by the likes of Lehman Brothers. Similarly, property investors bought new flats off plan in the UK and abroad only to find that rental demand was lower than expected and prices plummeted. Always remember, if something sounds too good to be true it probably is. Most importantly, investors should understand the risks they are taking.
6. Don’t be afraid to take profits (even if it means paying capital gains tax)Some of the biggest gains are lost by waiting too long before selling. The recent commercial property bubble is a good example, as is the technology boom. Investors who hang on for the peak invariably regret not banking some of their profits earlier.
7. Past performance is not necessarily a guide to the futureInvestors should be more concerned about how an investment will perform in the future than how it has performed in the past. As Warren Buffett once said, "the dumbest reason in the world to buy a stock is because it’s going up". The best time to invest is usually at the point of maximum pessimism rather than maximum optimism.
8. Keep your investments flexibleWhat do with profits bonds, structured products and buy to let property all have in common? You can’t get your money out when you want to – or at least you might suffer a penalty or costs for doing so. Nothing is more frustrating than watching an investment fall in value when you can’t do anything about it. Whenever possible, I’m a firm believer in using investments which allow you access to your money when you need it.
9. The stock market and the economy are not the same thingThe UK economy is in dire straights: the Government is borrowing an estimated £175bn this year desperately trying to stimulate a recovery. Against this backdrop of doom and gloom, the UK stock market has risen by 50% since March 2009. Naturally stock markets are linked to economic growth, but market forces - the numbers of buyers compared to sellers - makes far more of a difference. Stock markets are always trying to look to the future, whereas economic data must look at the past –they won’t always be telling the same story.
10. Economies are cyclical – good and bad times will happen again
Investors buy more on emotion than they do on logic and often have short memories. For example, the property market has crashed every 18 years since the 1970s and based on this we can expect it to crash again in or around 2025. In the meantime there will probably be a gradual recovery followed by another boom. Long term investors must accept they’ll have to face good times and bad times, and should prepare their portfolios for both.
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