As stock markets around the world tumble into a bear market, I am reminded of the experience I went through more than ten years ago.
For investors old enough to remember, the Global Financial Crisis was raging during 2008-2009.
It was sparked off by bad lending practices by banks to property owners who could not afford to service the interest on their mortgages. These were known as “sub-prime” borrowers, and the resultant crash in housing prices pushed the entire financial system to the brink of collapse.
Of course, every crisis is different. This time, it’s the insidious impact of a virus called Covid-19 that has wreaked havoc on financial markets and economies.
Though the reasons for each crisis differ, there are three important lessons I learnt from the previous market crash that I feel can be applied to the current, and future ones.
These timeless principles should stand investors in good stead as they navigate their way through challenging times.
Do not borrow to buy shares
During good times, borrowing money to buy shares may seem like a good idea to boost your returns.
However, the risks are hidden until an event such as a market crash exposes the downside of borrowing on margin.
When share prices plunge like they did over the past two weeks, investors who are investing with borrowed money may face a rash of margin calls.
A margin call is a situation where the value of the shares you own falls below the amount of the loan taken up, forcing the investor to “top up” the account with cold, hard cash.
During a crisis, the last thing we need is for someone to breathe down our backs, asking us to pay up.
If the margin account is not topped up, then the shares will be forcibly sold, crystallizing the losses for the investor.
I cannot repeat this enough — do not borrow money to buy shares. Period. It will save you a lot of stress and anxiety, especially when a market crash occurs.
Recovery may take place even when bad news abounds
Most of the time, the assumption is that bad news creates a vicious cycle, pushing prices lower while triggering increased pessimism.
While this assumption is not wrong, there comes a point during a market crash where further bad news has either limited or no impact on share prices.
To repeat an oft-cited cliché, this is known as the “point of maximum pessimism”.
It is the point where people have had enough of bad news. Further bad news, however shocking, has no additional psychological impact.
So, sentiment may improve when the news is less bad than anticipated. This will result in valuations and share prices heading up even though there is a steady stream of bad news.
I recall that many investors stood in disbelief when a rally took place in May 2009 during the deep depths of the financial crisis.
Most simply could not accept the fact that share prices could recover and head up even when bad news continued to trickle in.
Fighting human instinct
The final and most important lesson is also the most difficult one.
Market crashes trigger a “panic button” in all of us. Humans are conditioned by centuries of evolution to recognise danger and respond to it by fleeing.
Investors, however, should fight this instinct, bite the bullet and continue buying shares even as the market gets cheaper.
Though it may feel extremely uncomfortable to do so, the rewards will be great.
When the crisis is over (and yes, it will eventually pass, just like everything else in history has), you will thank yourself for acting decisively and not letting a great opportunity pass you by.
Get Smart: Keep calm and carry on investing
The above lessons apply to any market crash. Prudence and consistency are the hallmarks of a good investment process and will ensure that you can get through any financial crisis unscathed.
While things may certainly feel terrible right now, it’s important to view the situation in a positive light.
After all, you do not get many juicy opportunities to buy shares at bargain-basement valuations in your lifetime.
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