Two Lessons from the Global Financial Crisis

Ten Years Later: Two Lessons from the Global Financial Crisis

09/19/2018

With contributions from Tim Atwill, PhD, CFA, Head of Investment Strategy, and Tom Lee, CFA, Managing Director, Investment Strategy & Research


What have we learned from the global financial crisis? A decade has now passed since Lehman Brothers filed for Chapter 11 bankruptcy protection, the unofficial start of the meltdown, and a lot of ink has been spilled about how the landscape has changed—for banks, for markets, for the government, and for just about everyone who was alive at the time.


Parametric was alive at the time. In fact, we had a front-row seat to the spectacle as it unfolded, with lots of stressful days and nights as we helped our clients navigate the worst of it and, insofar as we could, make the best of it. (It was, as you can imagine, a good time for loss harvesting.)


The crisis was a difficult and often painful experience, but we came out of it with a couple of key lessons learned.


Don’t panic

It’s easier said than done. Many investors never imagined they’d lose 50% or more of their principal, and their first response was to head for the exits. To an extent, this was necessary: Institutions became underfunded or were up against other parts of their fiduciary structure or the needs of different constituencies. As a result, they had to de-risk at the worst possible time. What’s more, because they were responding to the crisis, it took longer for them to de-risk and it took a really long time for them to add risk back.


However, those who sell into fear usually regret the decision, while those who take on risk in times of fear are usually rewarded. Of course, it’s easy to see now why buying equities during the crisis would have allowed you to get in at the start of what, as you can see from the chart below, has been arguably the longest bull market in history. It wasn’t so obvious at the time.


S and P 500 Index total return chart

Source: Bloomberg as of 7/31/2018. Provided for illustration purposes. It is not possible to invest directly in an index. “Standard & Poor’s” and “S&P” are registered trademarks of S&P Dow Jones Indices LLC (“S&P”), a subsidiary of the McGraw-Hill Companies Inc.



The key takeaway here is having a strategy and a well-defined benchmark ahead of time so you don’t need to panic in the moment. Know your risk thresholds, understand the minimum amount of principal you need to hold on to, and define when to get back into the market. It’s also a good idea to set up systematic tax-loss harvesting, so that when opportunities arise you’re ready to take advantage of them.


Being proactive beats being reactive

If you’d known a strong recovery would follow on the heels of the global financial crisis, you might have sold long-dated puts (Warren Buffett did.) But most of us don’t have a crystal ball.


For our part, we’re not in the business of predicting the direction of the markets. But we are in the business of preparing for any given market direction.


That’s why “insurance” in the form of downside protection via assets with a low correlation to the equity markets is so important. As we shared in a previous post, blending low-correlated assets (such as alternative risk premia) with similar positive expected returns enhances diversification, reduces portfolio risk, and increases the odds of better and more consistent performance. Another form of downside protection is adopting strategies that exploit volatility. For example, tax-loss harvesting, systematic rebalancing, and volatility risk premium strategies all tend to thrive in a volatile environment.


Downside protection is a powerful thing—the more you can reduce a negative return, the easier it is to regain your losses. However, the return needed to fully recover from a loss isn’t symmetrical—indeed, one of the most painful lessons investors learned from the events of 2008 was that it takes much more than a 50% rebound to recover from a 50% loss. The chart below shows this pattern for various levels of losses and further reinforces the notion that downside protection plays a key role in portfolio construction.


Gains required to fully recovered from a loss chart

Source: Parametric



The bottom line

Legislation that followed the global financial crisis has made it unlikely that we’ll experience another bank-led meltdown. That doesn’t mean we’ve escaped the tendency of capital markets to crash. The capital markets are a harsh environment. They’re not designed for investors. They’re designed for capitalists, to help them fund their businesses and allow them to offload risk onto other people—investors.


That’s why it’s crucial to prepare your portfolio to be resilient in the face of risk. Develop a sensible, proactive investment plan, one you can stick to through the next market crisis, and don’t panic and sell at the bottom. You may not know what’s coming or when it will arrive, but you can at least be ready for it.

Potential Parametric Solution

A Custom CoreTM SMA allows investors to take charge of their passive mandates. Portfolios are held as separate accounts, giving investors the ability to customize them to their needs. Investors can select from a wide range of benchmarks and then tailor their exposure to incorporate their unique objectives.



Paul Bouchey

Paul Bouchey, CFA - Chief Investment Officer

Mr. Bouchey leads Parametric’s investment, research and strategy activities. His research interests include indexing, tax management, factors, and rebalancing. Paul earned a B.A. in mathematics and physics from Whitman College and an M.S. in Computational Finance and Risk Management from the University of Washington. He holds the Chartered Financial Analyst designation.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.

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