When difficult periods of market activity arrive, they remind investors of the importance of a disciplined approach to investing. The following discusses some of the lessons recently reinforced. 

Whenever a market crisis enters the picture, investors can count on certain words being bandied about in the media, such as unprecedented, new territory, unfamiliar and extraordinary.

The events themselves may well be unprecedented, but the basic lessons these events reinforce are not. But with the downfall of prominent companies such as Lehman Brothers, Merrill Lynch, AIG, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac), investors can take this opportunity to recognize some basic principles of prudent investing for the next time unprecedented market activity occurs.

What Happened
In the case of Lehman, the firm’s downfall was fueled by troubled real-estate investments. From 2004–2007, Lehman posted record profits, but also began accumulating billions of dollars in risky securities, loans and mortgages tied to real estate. This trend continued into 2008, as the company posted a profit in the first quarter while increasing its exposure to Alt-A loans (which are loans riskier than prime mortgages, but less risky than subprime).

As the values on those mortgages fell, the company attempted to raise additional capital, but was unable to do so. One of the final straws came shortly before the company announced its intention to file for bankruptcy. News leaked that talks involving a substantial investment from Korea Development Bank had failed.

Merrill Lynch faced a similar situation. Like Lehman, Merrill carried tens of billions of dollars in risky, hard-to-sell assets when the credit crunch took full effect in 2007. Those assets deteriorated in value, forcing the company to raise additional capital. However, losses continued to pile up, and subsequent attempts to raise capital did little to lift the company’s deteriorating stock price.

As The Wall Street Journal (WSJ) points out, AIG was healthy in many ways, but a single unit caused massive losses that weighed down the company. This unit sold credit-default swaps, which were designed to protect investors against defaulting assets, including subprime mortgages. “The division’s problems largely drove AIG to report $18 billion in losses in recent quarters, forcing AIG to put up billions more in collateral, straining its financial resources. Downgrades from ratings agencies and relentless pressure on the company’s stock exacerbated its already weak position.”¹

Market activity such as what has recently happened typically serves as a painful, yet necessary reminder of why equity investing has had greater returns than other, “safer” instruments. Risk is always present. However, bear markets also reinforce several other important investing principles.

Stock Prices Incorporate Known Information
Between January and September of 2008, several firms saw their stock prices battered as the market reacted to news about the health of each company. The firms mentioned above each saw their stock prices fall during 2008. However, investors still appeared to be shocked when each firm met its fate.
 

Such a move augments the notion that markets incorporate known information into stock prices. In the case of these companies, the market recognized that they were in trouble, and the stock price fell. However, the market did not know the full extent of the trouble until each company met its fate. This is reflected in the changes seen in the stock prices in September. In all but one case, the price fell more percentage-wise in two weeks than it had since the beginning of the year.

Individual Stock Speculating
Consider the cases of investors who held individual shares of some of the battered companies. The collapse and subsequent takeover of Fannie Mae and Freddie Mac left many investors in its wake.

The WSJ discusses the tale of one investor who believed he could profit from the situation at Freddie Mac. In early September, this investor purchased about 25,000 shares of the company at $5 per share, believing the price would rebound. Instead, the government takeover drove the price down significantly further. “Now he says he is out more than $100,000 — money that he was saving for his young sons’ college education.”²

About the only solace this investor may find is knowing that even the most reputable of investors fell victim to investments in these companies. Famed investment manager Peter Lynch disclosed that he held Fannie Mae — which he has cited many times as a favorite stock — in his personal portfolio because he believed the company would post big earnings in 2011. “‘I can be just as dumb as anybody else,’ he says wryly.”³

Diversification
Lehman Brothers in particular reinforced the notion that investors should be wary of holding significant percentages of their assets in their company’s stock. Shortly after the news about the impending bankruptcy broke, the WSJ noted in a September 12 article that Lehman employees lost about $10 billion in paper wealth when the stock price plummeted to $4 per share. The employees owned an estimated 25 percent of the company.⁴

To say that Richard Fuld, the company’s CEO, held a significant stake in the company might be an understatement. Fuld had accumulated 10.9 million shares of Lehman stock during his 41 years with the company. As of January 31, those shares amounted to a worth of $695 million. That September article showed those shares had plummeted 93 percent in value, leaving Fuld holding shares worth $45.8 million.

However, the freefall did not stop there. Two weeks later, the WSJ reported that Fuld sold some of his shares after the company filed for bankruptcy. By that time, the share values had dropped to mere pennies, and Fuld sold 3.17 million shares (or about 30 percent) for $660,209.⁵ One can only wonder just how much equity vanished from the portfolios of other Lehman employees. Remember, the $10 billion in equity that Lehman employees lost was cited when the company’s stock was hovering at $4 per share, not the pennies per share where the stock currently sits.

Hindsight Bias
Investors may also hear about how “inevitable” each company’s downfall was. By now, some may be convinced that anyone who was paying attention could have seen each of these situations unfold long before it actually happened.

However, investors should be wary of the instinct to view such situations as easily recognizable. This sudden inevitability has another side effect, one that can be even more damaging to investors and their portfolios. In a September 16 article in the WSJ, columnist Jason Zweig points out that looking back at what now appears to have been obvious could create problems for investors as they look toward the future.

“By retroactively fooling us into thinking that we knew how the past would unfold, hindsight bias tricks us into thinking we know how the future will unfold,” Zweig writes. “But if the past took you by surprise, why should you believe you can decipher the future?”⁶

He related the story of Scott Jaffa, an investor who called the September 15 stock market plunge a test of his psychology.

“Because he does not need the money ‘for another 30 to 40 years,’ he asked rhetorically, ‘why should I worry myself about its performance over a period of days or weeks or even months?’”⁷

Investors would do well to follow in this investor’s footsteps. But as Zweig pointed out, it does not come naturally. “A year and a half ago, Mr. Jaffa destroyed the online access code for his 401(k) so he could no longer have instant access to his retirement accounts. His goal was to make it ‘significantly harder’ and to require ‘human interaction’ before he could trade on his emotions. That enabled him to watch the market's decline without acting on it.”⁸

Summary
Investors can look to their advisors for help controlling such emotions. A good advisor will help clients remember the importance of adhering to their well-developed plan.