Investor Psychology

Lessons From the Crisis

13 maxims for the times.

As the U.S. slowly pulls out of a brutal two-year slump, it's time to reflect on what we have learned

Debt can be deadly. Leverage (the fancy word for debt) magnifies gains in rising markets—and magnifies losses when prices crash. Credit is a valuable tool, but it must be used sparingly.

Cash is king. Those with liquidity can scoop up bargain assets in falling markets. But money tied up in illiquid assets—including real estate partnerships, hedge funds and private-equity pools—can't be retrieved on short notice and must often be shored up by cash calls.

Easy credit helps no one. Overmarketing credit cards and mortgages to marginal borrowers does them no favor, and their debt is not a safe asset for anyone to own. Plus, cheap money encourages companies to overpay for acquisitions.

When others panic, buy. Just as during every financial crisis in world history, the market swoon from late 2008 through early 2009, with a 43% drop in the Dow, was a great time to load up on quality stocks to hold for a long time.

Forget about "decoupling." The idea that high-growth developing economies—and their stock markets—would be immune to severe recessions in Western nations turned out to be a myth.

Governments should anticipate recessions. During boom times, they should stockpile revenues in rainy-day funds as a hedge against lower tax receipts and expanded social needs ahead. When surpluses are set aside, they smooth out government spending and avoid the pain of public-employee layoffs and cuts in vital programs.

Free markets need oversight. A pro football or basketball game without sensible rules and tough referees would quickly deteriorate into bedlam. So would financial markets. But a whistle-happy ref can also spoil the game. Effective oversight finds a balance between safety and innovation. High compensation breeds risky behavior. It's time for shareholders—among them Uncle Sam—to rein in excessive rewards for short-term results.

Complexity breeds chaos. Exotic financial instruments designed to dampen risk often have the opposite effect, especially when oversold to uncomprehending managers of pension funds, endowments and mutual funds. Investors: If you don't understand it, don't buy it. Regulators: If a new kind of asset has no good reason to exist, have the guts to just say no.

Securitizing doesn't change risk. Slicing an asset into small pieces just spreads the prospective gains and losses over more owners.

"Too big to fail" must entail consequences. As a price for being allowed to become gigantic, financial firms must be subject to more government oversight, such as higher capital reserves, higher deposit-insurance fees and more scrutiny of their operations.

Home is shelter, not an investment. Home prices can and do rise and fall, like all other assets. Don't expect appreciation in the value of your home to be a substitute for retirement savings in traditional investments.

Washington grows by default. For good and for ill, the federal government always expands its spending and authority in times of crisis—by popular demand. And it takes years to pay down the debt and assess the wisdom of new controls.

Living beyond our means is over. The U.S. is dangerously dependent on foreign creditors because of excessive borrowing by Washington, excessive consumption of imports (primarily petroleum) and a personal savings rate that has been near zero (rising recently to 5%, but still too low). Foreign lenders won't cease funding our deficits, but they will demand higher interest rates to do so.

These are some of the painful lessons we've learned. But will we remember them when the crisis is past?

Columnist Knight Kiplinger is editor in chief of Kiplinger's Personal Finance, The Kiplinger Letter and Kiplinger.com.

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