"What investment lessons should be learnt from the global financial crisis" - Essay Example

Investment lessons from the global financial crisis It is almost seven years since the occurrence of the worst global financial crisis. The 2008 financial crisis marked some of the worst periods globally in financial market history. The financial crisis occurred due to factors such as underpricing of risks and lack of institutional transparency, which led to the loss of investment after the bubble burst. The Global financial crisis provided an opportunity that tested many economic assumptions while creating a learning platform for investors.

Investors were increasingly aggressive over the years prior to the global financial crisis, pursuing what most investors saw as easy money due to exposure to credit and used where it should not. To understand some of the lessons investors learnt from the financial crisis, an investor has to understand the causes. Smith and Marshman state that the triggers involved rising role of finance in the economy, which led to increased leverage, layering of debts and use of gross domestic product for interest rather than profit (1).

The following are some of the lessons investors should learn from the global financial crisis. Diversification is essential to risk control. The global financial crisis was a volatile time for investors, particularly those in the share markets. Before the crisis, stocks posted double-digit gains consistently until the crisis hit, and they came out bursting from the bubble. An investor should aim at reducing risks in an investment portfolio through diversification to prevent losing value on the entire collection.

Spreading your portfolio across different investment options like stocks, mutual funds, and bonds across various industries minimizes your financial risk. Since the global crisis, the world economy is in a constantly changing state and matching an underlying investment to the same volatility level is critical. Smith and Marshman state that, the global financial crisis illustrated how primary exposure and asset classes become correlated than any testing would ever suggest (1). Most investors were used to the financial markets massive rewards prior to the global crisis; during the crisis, some left the market with weak portfolios while others adjusted their portfolios and emerged with better recoveries.

Panicking of investors saved them the trouble of enduring sleepless nights but also limited them from the best advances. Learn to embrace change. Hesitation to change, even when the environment has changed, results to poor returns. Though human instinct seeks to support recently made decisions, a change in the financial environment should be followed by changes in previous decisions. Any investor should have knowledge of the economy’s financial trends and should adapt to the changes in these trends.

Investors should not be hasty in making decisions until they have a proper understanding of the implications of the structural decisions. Smith and Marshman state that the timing of investment volatility is as crucial as its resulting magnitude (2). Most investors lack adequate knowledge on management of their portfolios when markets decline and they end up selling at near the bottom rather than adjust accordingly. Management of a portfolio in embracing change can result in a rebound especially after a big selloff by others who end up inflicting long-term adverse effects on their portfolio.

Avoid emotional investment. A plummet in real estate pricing tied to U.S. securities occurred after the bursting of the U.S. housing bubble. Due to this increase, people feared for the continued increase in house prices and accessed loans to acquire houses. Financial institutions provided commitments that were not backed by their inadequate capital holdings, therefore, failing to price mortgage risks accurately. An increase in the real estate pricing caused a housing bubble that led to most people refinancing their homes or taking second mortgages as a result of price appreciation.

Due to this, an enormous pool of money was created, but the supply of investment was small. Investors greedily invested in Wall Street products such as collateralized debt obligations. Funds invested with greed were obtained by financial institutions and used to fund the mortgages extending the housing bubble. Securities received with lower priority had a higher rate of return on the amount invested. Always manage your liquidity. Following the global financial crisis, investors have been reminded that large allocations to investments that are illiquid provide greater risks in addition to standard market changes.

According to Smith and Marshman, when investors do not retain sufficient liquidity, they end up selling their assets when the market gets highly illiquid (1 &2). A long-term investment is usually disrupted to cater for short term liquidity. The global financial crisis arose because most people depended on credit for management of their cash needs. Investors with low liquidity needs are at a better chance of enduring market volatilities, and can invest aggressively while those with high liquidity needs ought to be more conservative.

In 2007, most people with high liquidity needs began to default on payment of their debts like mortgage, leading to the loss of property and others filing for bankruptcy. Maintaining adequate liquidity within an overall investment ensures that investors do not sell their depreciated investment at inopportune times. Liquidity regularly requires replenishing with prevailing market conditions like interest rates. Investors who had traded in or stocked cash or government bonds emerged more successful after the financial crisis than other investors who traded in stocks.

Invest in what you understand. Most financial management institutions offer incentives that seek to attract investors with their hard earned money. In most cases, an investor is tricked into investing by the use of management incentives without the investor’s interests in mind. Smith and Marshan state that due to increasing financial leverage by investment banks, investors were left vulnerable to economic shock (2). When investors rely on ratings provided and management incentives offered they risk falling for a scam and losing their investment.

Investors learn not to purchase anything they do not understand, and they should not let their credit managers indulge in any purchases without their consent. Most investors were not aware of the risk inherent in the acquisition of several financial market products. Following the global financial crisis, people have argued that the lack of transparency prevented financial markets from properly pricing risk. As the valuation of financial markets became harder, investors were duped into buying without adequate knowledge of the risks associated that were projected to be much smaller than they turned out to be.

In their research Smith and Marshan found that superannuation funds have adopted a conservative approach rather than the growth investment option (2). The impact resulting from this approach led to the lack of ability to implement optimal investment among most investors. Avoid investment imitation. Just because other investors are making so much from an investment is not a sufficient reason to venture into the same investment. Informed investment is the way forward to making money in any environment.

An investor should buy products based on the merit of the advice and not on who has invested. Global financial crisis occurred even after Wall Street’s forecasts predicted a continued increase in real estate pricing based on their data since 1945 and the assumed fact that house prices do not go down. The crisis, however, was marked by depreciation in pricing, resulting in decreased leverage even with the investments made by Wall Street. Rather than investors imitating other investors, the best option would be discussing with their financial advisors and noting down all possible obstacles they are set to encounter in their investment.

In most cases, financial planners require an investor to sign a form detailing how much volatility they wish to accept. The documents only prove that most financial analysts rely on statistics and academic expertise with no experience in real life business investment. Exempting them from litigation by signing their forms only makes it worse since there is nothing an investor can do once financial managers invest poorly for them. To avoid massive losses, an investor should ensure the financial planner outlines all the risks in the investment.

Maintain good financial habits. One of the biggest causes of the global financial crisis was the lack of efficient underwriting standards. Banks and other financial institutions provided loans without checking the financial capacity of borrowers. Assumptions of future appreciation of real estate pricing saw borrowers acquire financing and second mortgages in the thought that the market would maintain equilibrium. The global financial crisis saw the depreciation of real estate pricing, and borrowers were unable to meet the lenders expected payments.

A seizure of these houses could not cater for the actual amounts leading to the sinking of both the borrower and the lender. To prevent these from happening financial institutions have reduced incentives offered and come up with stringent measures to ensure loan advancement to the credit worthy. Investors are now expected to show a claim of their credit worthiness, and they can achieve this by avoiding unnecessary debts. Investors should also refrain from providing or venturing into investments especially with companies with huge debts in the name of spreading risks.

Smith and Marshan state that even with the falling of prices and incomes investors should know that debt service payments are always advancing. Uncalled for loans may seem like an easy way to acquire money but they can lead an investor into an abyss of disaster when not invested wisely. Plan for long-term investments. Long term investment is an art when well mastered helps put the favors on the investor (Smith and Marshan, 4). Long term investments attract better management incentives compared to short-term investments.

Due to high taxes and inflation, short term investment draws minimal returns while long term investments have high average real returns. Smith and Marshan state that the best way to overcome situations like those brought about by the global financial crisis is to forgo returns for some years (4). Short term investors rely on the short-term performance of the said companies and when the company underperforms the investor is likely to lose while asset managers end up gaining from this loss. In investing on a short term basis, investors should avoid stocks and opt for conditionally risky assets including bank deposits, government bonds, and public company bonds.

Short term investment requires knowledge of both monetary and fiscal policies. Fiscal policies rely on the government’s rate to control cash flow by increasing or decreasing its spending and taxes. Monetary policies are those measures applied by the central bank and other financial institutions to regulate cash flow and include high or low-interest rates and management incentives for borrowing and other lending measures. Be wrong but don’t stay wrong. The global financial crisis proved that securities, asset classes, and markets are all prone to failure.

An investor must understand that any investment has an equal opportunity to succeed or fail. Before the financial crisis, investors were wary of tech related markets expressing optimism in the banking sector markets. The financial crisis caught investment managers by surprise given the confidence most of them expressed with the banking industry. An investor has to be prepared for the unexpected at all times, including swings encountered in the economy and financial markets. Investors should always learn from their mistakes and the mistakes of others.

Avoiding highly leveraged corporations is a good thing. The avoidance is because these organizations depend on the returns on equity which entail riskier assets or denial of risk of loss. The rate of acceptance when an investor, makes a wrong investment, determines how well the investor will respond to changing environment. Not to make wrong decisions, an investor should realize that stocks of financial investments are not a great idea in a crisis. That said an investor should ensure that the global financial crisis was a painful well learned lesson and use it in the acquisition of investment goals.

An investor should pay attention to all details before investing or engaging in most economic practices. Though the government and financial institutions can place regulations like monetary and fiscal policies, an investor should be vigilant when it comes to investing. The modern financial system is growing at a rate that no system of rules and regulations can match. The bailout by governments made it clear to investors that institutions and corporations will always come first in the formulation of policies.

Investors lost most of their investment to organizations and during compensation these corporations got to benefit. At all times, the investor needs to practice diligence investing and avoid rushed decision-making or decisions based on emotions. Success in investment depends on the decisions made by an investor and making the right decision is dependent on a set of macro and microeconomic information. Even though it happened during the great financial crisis, people should not expect the government always to interfere and rescue markets or interfere with contract laws.

Government bailouts and rescues cannot occur sufficiently and predictable for investors to take advantage of especially where the government can defer the expenses to the future. Work Cited Smith, Duncan, and Ken Marshman. “Lessons Learnt from The Global Financial Crisis.” JANA, 2009. Web. 21 March 2015. < http://www.jana.com.au/wp-content/uploads/2012/01/Lessons-Learnt.pdf >.