Market Watch: Two Lessons From Lehman Brothers 2008 Collapse Can Save Your Investments

Article by Mark Hulbert on WSJ Market Watch

September marks one of the most important anniversaries for investors who want to learn the lessons of history. Unfortunately, I doubt this anniversary will receive much notice.

I’m referring to the September 2008 bankruptcy of Lehman Brothers, which up until then had been the nation’s fourth-largest investment bank. Its bankruptcy was the largest in U.S. history.

Those of you with good memories will recall how momentous that bankruptcy was. In its wake, several prominent money-market funds began “breaking the buck,” which had never happened before. That meant that the funds were unable to maintain their net asset value and began selling for less than $1 per share. Many industries came to a virtual standstill as liquidity dried up literally overnight.

Not surprisingly, the stock market plunged: The Dow Jones Industrial Average sank 25% over the next 30 days — one-quarter of its value in just four weeks.

Think about that for a minute. If a similar drop were to occur now, the Dow would drop around 6,500 points between now and the end of September, bringing it to around 19,500.

The first investment lesson you should draw from this anniversary: A drop of such magnitude could happen at any time. This lesson is quite important, because the risk of such a big drop in a short period of a time is an inevitable feature of the stock market. That’s what market risk entails.

If you can’t stomach that much risk, then you should reduce your equity exposure to whatever your tolerance level is. And the market being at or near all-time highs is a good opportunity to reduce exposure.

The second investment lesson I draw from the anniversary applies to those of you who think that you can sidestep any such decline. My decades-long performance tracking of stock-market timers gives me little confidence that you will succeed.

Consider the stock-market timers I monitor who sported the best track records going into September 2008. On average, they had far higher equity exposure levels that month than those with the worst records — despite the market being on the verge of going over a cliff. As you can see from the accompanying chart, this conclusion applies regardless of whether you measure performance over as short a period as the trailing five years or as long as the trailing 20 years.

In other words, you could have done everything right going into September 2008 and still lost a huge amount of money — more, even, than those who did everything wrong. Even if you had chosen your stock-market timer on the basis of a market-beating approach over the long term, for example, chances are good that you nevertheless would have lost more money than the followers of other market timers with terrible long-term records.

No good deed goes unpunished, does it?

These two investment lessons would be important to draw at any time, but especially now in what most would agree are the latter stages of this bull market. It’s times like these when investors naturally gravitate toward the greed end of the fear-versus-greed spectrum, in the process losing a healthy sense of respect for the stock market’s inherent risk. It’s not too late to show that respect.

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