What Should We Learn From the Financial Crisis?

Economists have begun to argue about what we should learn from the financial crisis. Some believe better regulation could have prevented the crisis. Others suggest that the monetary authorities caused the crisis by holding interest rates too low. Some insist that the government stimulus is essential to pull us out of the recession. Others are not convinced.

It will take years for economists to agree on what the recession can teach them. However, we can learn (or re-learn) several uncontroversial lessons that apply to our own day-to-day financial lives and longer-term financial plans right now.

You can influence many of the factors your financial security depends on, even if you cannot control all of them.

Your Job: For families with members in the working phases of their lives, human capital or earning power is one of their largest assets. Losing a job or having to accept a pay cut or reduction in working time can be a significant blow to your financial security. To limit the potential impact, you can:

— Recognize the risks associated with your job.

• Do you work in an industry that seems to react less to changes in the economy such as health care or education (lower risk) or is your industry an economic indicator like automobiles or hospitality (higher risk)?
• Is your employer a market leader with a stable market position (lower risk), or a marginal participant whose revenues react dramatically to changes in the economy (higher risk)?
• Are you the sole breadwinner in your family (higher risk) or is your spouse also employed (lower risk)?

— Manage your economy-linked income risk.

• Try to position yourself for less income risk by moving to a more stable employer, or in the longer term, to a more stable industry.
• Develop your skill set so that you can move to another industry or function should the need arise.

— Insure your personal income risk.

• Be sure you have enough life and disability insurance to protect your family against the loss of your income through either premature death or the inability to work.

Your Savings & Investments: If there is a lot of risk associated with your job, you should save more and invest more cautiously.

• Maintain a larger emergency fund: If you are likely to lose your job or have your hours reduced, a pool of cash will help tide you over until your income returns to normal.
• Maintain a smaller exposure to stocks in your investment portfolio: If your earnings fluctuate with the economy, when the economy performs poorly your employer might reduce your hours or you might lose your job. Your stocks might lose value at the same time — a double whammy.

Your Borrowing: Leverage places where your financial plan is at risk, especially if your job has income risk.

• Leverage is just a fancy word for borrowing. Borrowing commits you to make regular payments. These commitments reduce your financial flexibility — you must continue to pay even if your income stops, or consequences ensue (e.g., damage to your credit rating, repossession of your car, loss of your home, etc.).
• Larger commitments mean greater reductions to your flexibility and resilience.

Real estate is a risky asset, house prices can decline, not just increase.

• In most markets, house prices declined 20 percent or more.
• Some of us were fortunate: Prices of our houses have declined less, or not at all. We’d like to think we were smart, that we chose houses in markets that were safe, and will always be safe. My strong suspicion, although of course I can’t prove it, is that it was luck (prices in your neighborhood could fall the next time).

Changes far away in the economy can threaten your job (and if your employer is not a market leader, the risk is greater).

— This time, the big economic changes (causes of the crisis) were in the housing market (dramatically overbuilt and overpriced) and in financial markets (e.g., toxic assets).
— Corporate bankruptcies and major job losses occurred in marginal, less profitable, and less successful employers in other industries (although housing and financial companies were affected too):

• In the automobile industry, GM and Chrysler failed, not Toyota.
• In retailing, Circuit City failed, not Wal-Mart.

Bonds paying higher interest really do have more principle risk. For example:

• Lehman Brothers bonds defaulted.
• Auction rate securities became illiquid.

Stocks really are more risky than bonds.

• Stock prices declined 53 percent from October 2007 to March 2009.
• Diversification did not provide protection — all stock indices declined comparable amounts.

If it sounds too good to be true, it very probably is:

• Bernard Madoff promised prospective clients 10 percent annual returns without risk. His investors received statements reporting returns at that level. Unfortunately, few of them checked to confirm whether or not there were underlying investments supporting the reported results. As we now know, there were no investments at all.
• This is especially difficult to remember when all your friends seem to be “in on a special deal.” Madoff and his money sources took advantage of this “friend effect.” Always seek the advice of an objective, disinterested third party when considering an “opportunity” of this sort.

Rick Miller
Founder
Sensible Financial Planning & Management
Cambridge, MA

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