Darrell Cronk, CFA®
by
President, Wells Fargo Investment Institute

The date was September 7, 2008 when the federal government announced it was placing Fannie Mae and Freddie Mac into conservatorship, effectively nationalizing each of them. Panic spread across Wall Street as these entities owned or guaranteed almost half of the existing U.S. mortgage market. The following almost unbelievable week, Merrill Lynch was sold to Bank of America; Lehman Brothers filed for bankruptcy protection; Moody’s and Standard & Poor’s downgraded American International Group (AIG) forcing the Federal Reserve to lend $85 billion to avoid its bankruptcy; the Reserve Primary Fund (a large money market fund) “broke the buck;” and legislators met through the weekend with Treasury and Federal Reserve officials to craft a proposed $700 billion emergency bailout of toxic assets.

The impact of these two weeks in early September 2008 was tectonic in nature. Like all big seismic events, these two weeks altered the landscape—in this case, the financial, government and commerce landscape—in unimaginable and permanent ways. In the day-by-day, and almost hour-by-hour, sequence of shocking events, the powerful logarithmic waves of damage showed just how interconnected we all were within the financial system. 

While scar tissue has hardened for many who lived through these turbulent events, it is important to remember the dizzying fear that shook our financial foundations and draw lessons from the worst financial crisis since the Great Depression. A decade later, I want to expound upon three powerful lessons, understanding there are many more we could discuss at length.

  1. Risks in portfolios can often be more complicated and complex than they first appear. Real diversification too often is in short supply. However, we believe one of the greatest lessons learned is that it is imperative to remain disciplined in exercising wise, diversified choices. Investors can’t fully immunize portfolios against volatility, but with an effectively diversified portfolio and a systematic approach to rebalancing, we believe they can avoid making harmful financial and psychological choices at exactly the wrong moments.
  2. Leverage can be a useful tool when used in moderation. Clearly, financial risks shifted in unexpected ways during the crisis, with many failing to understand the effects of liquidity, leverage and confidence and how rapidly they can deteriorate. Animal spirits and crowded places can create additional risks when shockwaves arrive. There is often comfort in the warmth of the “herd,” but it rarely serves investors well. We believe investors are better served by disciplined management of liquidity and leverage and by keeping portfolio exposures consistent with long-term goals and investment plans.
  3. Risk management all too often becomes an afterthought following a financial crisis rather than a forethought. It is well known and documented that those who lose the most during financial crises are either those who panic and choose to sell or are forced to sell at the most inopportune moments. We don’t know when the next crisis will arise. (After all, it wouldn’t be a crisis if everyone expected it.) But we can be certain that there will be another one and that our preparation will be a key to how we weather it. Too often, like the generals of old, people look to where the last war began rather than where the next one may be incubating. History teaches us well that this strategy is flawed. Addressing risk management in advance, and reviewing portfolio risk relative to goals on a routine basis, can keep us grounded and flexible when the next inevitable tremors rattle the foundation.

Unfortunately, financial shocks are an inherent part of developed and developing financial systems. Believing otherwise would be inconsistent with what centuries of history have taught us. Investors who understand where risk lies within their portfolios, who address position concentrations that can have ill effects in a crisis, and who are proactive in their preparations may best be able to navigate the next seismic event, whenever it makes its surprise appearance. 

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