5 Lessons from the Lehman Brothers Collapse

We've recovered from the financial catastrophe triggered by the investment bank's demise, but investors need to remain vigilant against future disasters.

On September 15 five years ago, the world awoke to a financial calamity: One of the nation’s largest investment banks was collapsing, unable to meet its obligations. The Lehman Brothers bankruptcy, in turn, triggered the near destruction of the entire financial system and the worst recession since the Great Depression.

The U.S. stock market, which had started falling almost 12 months earlier, plunged. Standard & Poor’s 500-stock index eventually lost 55.3%, hitting bottom on March 9, 2009.

What can we, as investors, learn from the collapse and its aftermath? Here are the five most important lessons I’ve gleaned.

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1) Bubbles happen fairly often. When it comes to markets, it’s not unusual for prices to soar to irrational levels. Whenever that happens, you need to tread carefully.

Sometimes bubbles are easy to spot. In the late 1990s, tech stocks sold at ridiculous multiples of sales and earnings (assuming a company had profits, which often wasn’t the case). The problem for investors then was that it took years for the seemingly obvious bubble to pop. It was maddeningly difficult to stay away from overpriced stocks because they kept rising for so long. The real estate bubble was likewise pretty easy to see. But few people guessed a fall in home prices would endanger the entire economy.

Watch out any time you hear, “X always goes up” or “This technology will change the world.” Nothing always goes up. New technologies can change the world, but only a few investors get rich from them. Plus, tech changes so rapidly that today’s innovations become tomorrow’s abacuses.

Bond prices have been falling lately, popping a bubble in the fixed-income market. The false premise behind that bubble was that bond yields were guaranteed to stay low—and bond prices, which move inversely with yields, would stay high—as long as the Federal Reserve wanted. The Fed can control short-term yields, but the market ultimately sets long-term bond yields.

2) Don’t overdo stocks—or any other investment. Over ten-year periods, stocks have almost always achieved much higher returns than bonds. Meanwhile, cash, or money in the bank, has done little more than keep even with inflation.

But putting all your money in stocks, as many advised in the 1980s and 1990s, proved to be far too risky. Over the long haul, large-company stocks have returned about 10% annualized, bonds have returned about 5% annualized, and cash has returned a little over 3% annualized--about the same as inflation.

But stock bear markets are brutal and usually impossible to forecast. Owning some bonds—even today, when interest rates seem almost certain to go higher—always makes sense. So does holding some cash.

3) Invest in high-quality stocks. Many of the smartest investors practice value investing. Over the long term, value stocks—stocks priced cheaply relative to earnings and other measures—have beaten the market. Ditto for stocks of small companies. And the best returns of all have come from bargain-priced small-company stocks.

But in the 2007-09 bear market, the Russell indexes of value stocks, small-company stocks and small-company-value stocks each tumbled three to four percentage points more than the S&P 500.

Meanwhile, funds that specialize in high-quality stocks—large companies with low debt and steady earnings growth—held up much better than the S&P. I can’t find a good index of high-quality stocks, but among high-quality funds, Vanguard Dividend Growth (VDIGX) lost 42.3% and BBH Core Select (BBTRX) fell 41.3%. (The Vanguard fund is a member of the Kiplinger 25; the BBH fund was removed from the Kiplinger 25 after it closed to new investors.)

I’m not suggesting that you shouldn’t invest in stocks of undervalued companies or small companies. To the contrary, I think you should diversify your stock investments broadly. But don’t load up on value or small-capitalization stocks—unless they are really, really cheap, as they were before the 2000-02 bear market.

Emphasizing high-quality stocks makes a lot of sense to me, even though they usually command premium prices and tend to lag during bull markets.

4) Financial stocks are cheap for a reason. Relative to earnings, assets and other measures, bank stocks are usually cheaper than the broad market. That shouldn’t come as a surprise. Every ten years or so, financial companies get into some kind of mess. All that borrowed money eventually leads to trouble, regardless of what the regulators do to mitigate the risk of that happening.

5) Don’t expect to get the big picture right. In the days and weeks before the Lehman disaster, only a handful of investing gurus were predicting the horror that was about to befall us. Afterward, those who got it right were lionized, and many investors felt foolish that they had missed the warning signs.

But many of those brilliant bears have stayed bearish—even as a ferocious bull market has more than made up for the losses of the worst bear market since the 1930s.

It has been my experience that the bearish case regarding the stock market is almost always more convincing and intellectually more compelling than the bullish argument. But get this: Usually and ultimately, the bulls have been right. I expect that to continue.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

Steven Goldberg
Contributing Columnist, Kiplinger.com
Steve has been writing for Kiplinger's for more than 25 years. As an associate editor and then senior associate editor, he covered mutual funds for Kiplinger's Personal Finance magazine from 1994-2006. He also authored a book, But Which Mutual Funds? In 2006 he joined with Jerry Tweddell, one of his best sources on investing, to form Tweddell Goldberg Investment Management to manage money for individual investors. Steve continues to write a regular column for Kiplinger.com and enjoys hearing investing questions from readers. You can contact Steve at 301.650.6567 or sgoldberg@kiplinger.com.