Past bubbles offer lessons for advisers

The deflation of the housing and mortgage bubble should reinforce several lessons for investors and their advisers.
First, if it looks like a bubble and if you hear the phrase, “This time it’s different,” it probably is a bubble, and will eventually burst.
Second, even investors who think they have avoided the riskiest investments may be hurt by the collateral damage of a bursting bubble.
Third, the Wall Street wizards who put together esoteric investment products such as collateralized debt obligations are out to make money for themselves and care little about the long-term viability of the packages once they sell them (unless they are foolish enough to start hedge funds to invest in them).
Fourth, if investors reach for higher returns, they will inevitably be taking higher risk, as shown by the fact that even higher tranches of some CDOs have been hurt by the fallout from the evaporating mortgage bubble.
Tech-stock seduction
Some of these lessons, such as the first and second, should have been learned in the 1999-2001 period when the technology bubble reached its peak and then burst.
During that period, anyone who warned that the tech bubble was getting out of control was told in no uncertain terms, “This time it’s different.” It wasn’t.
Millions of investors were seduced into investing in tech stocks, often through mutual funds that invested in those stocks.
Mutual fund portfolio managers and individual investors were lured by the siren songs of optimistic projections of fast revenue and earnings growth, and high investment returns.
Investors thought diversification through professionally managed mutual funds would protect them. It didn’t.
Even index funds that were supposed to protect investors from the risk of overinvesting in a specific sector didn’t protect as well as they were expected to. In part, that was because the capitalization-weighted indexes became heavily invested in some large, fast-growing tech stocks.
But it was also because when a bubble bursts, the whole stock market often takes a hit.
Many experts scoffed at the possibility of the housing/mortgage bubble bursting. This time it will be different, they said.
Looks like they were wrong again. So far, the bursting of the housing/mortgage bubble has mainly hurt housing prices, housing-related stocks, the mortgage market and esoteric fixed-income securities, though as of last week it had taken about 5 percentage points off the market gains for the year. But the effect could easily spread further if more bad news arises.
Investors and their financial advisers also should have learned before to be skeptical of Wall Street’s hot products that appear to offer above-average returns.
One example is CDOs, which Wall Street sliced into tranches that supposedly matched the risk/return profiles of different investors.
No warranty
Risk-averse investors supposedly could get better-than-average fixed-income returns with little risk by buying the higher tranches.
Guess what happened? Even those higher tranches have been hit in some CDOs by the collapse of the sub-prime-mortgage market.
Wall Street doesn’t deliberately put out flawed products. But, unlike the auto or appliance industries, it doesn’t offer a five-year warranty on its products.
Therefore, the old adage, “buyer beware,” should be changed to “investor beware.”
And investors and advisers should internalize the lessons of the bursting of this latest bubble.
Meanwhile, there are still three bubbles evident in the economy: A hedge fund bubble, a private-equity/leveraged buyout bubble and an infrastructure bubble, all driven by investors seeking above-average returns.
Investors should hope these lessons aren’t further reinforced by the bursting of these bubbles. If that were to happen, the costs of the lessons would rise exponentially.