A year of painful lessons

Investors will be glad to see the end of 2008 — a year that may live in infamy as one that was marked by the worst investment returns since the Great Depression. But the end of such a year is an excellent time to look back to determine what lessons should be learned from the crisis.

Perhaps the first lesson for investors is that if something looks like a financial bubble — that is to say, if prices for an asset class are far above historic norms — then it probably is a bubble. And eventually, it will burst.

A key warning sign is when in-vestment gurus dismiss concerns about rising asset prices with phrases such as: “But this time, it’s different.” It was not “different” in the Nifty 50 bubble of the early 1970s, the technology bubble of the 1990s or the housing bubble of the past eight years. Another warning sign is when Wall Street starts pushing such “low-risk, high-return” investment vehicles as triple-A-rated securities backed by subprime mortgages to individual investors.

A second lesson is that when a bubble bursts, its effect may be felt in asset classes other than the one in which the bubble occurred. That’s been the case over the past 15 months when the bursting of the real estate bubble caused secondary explosions in not only the domestic-stock and corporate-bond markets but also international-stock and bond markets.

A third lesson is that it’s almost impossible to guess when a bubble will burst.

Bubbles are especially dangerous because they tempt investors to deviate from sound, long-term investment strategies to pursue the apparently higher returns in the bubble asset class.

Investors who want to try to profit from a bubble should keep their bets small. Those that get caught up in the euphoria of a bubble and make large investments will eventually suffer painful consequences — especially those who enter late.

As an example, look at those who sought to profit from the housing bubble by buying and flipping homes. Early entrants made money, but those who entered late or stayed with the strategy too long now find themselves stuck with costly, illiquid properties.

“Bears make money, bulls make money, but pigs get slaughtered” — the old Wall Street saying — still holds true.

A fourth lesson is that a properly diversified portfolio doesn’t always provide complete protection when a bubble bursts, but it can reduce the severity of the losses.

That said, a portfolio that holds many kinds of domestic and international stocks is not a diversified portfolio.

A diversified portfolio holds many different asset classes that have varying correlations with one another, including relatively low-yielding, but safe, U.S. Treasury notes and bonds.

Another lesson from this crisis is that investment returns alone cannot guarantee a comfortable future. Investors must not spend beyond their means and expect investment returns on their 401(k)s to do the heavy lifting in terms of preparing them for retirement.

Many baby boomers now find themselves approaching retirement with insufficient resources because they expected to live on their investment returns and income derived from their homes, both of which have dropped precipitously in value over recent months.

Financial planners and investment advisers have the opportunity to drive home these lessons as they meet with their clients to review the sad facts of 2008. They also have the opportunity to tweak the investment strategies of clients to prepare for the recovery we all hope the new year will bring.