This Time it’s Different

These words are often referred to as the four most dangerous words in investing. They are often uttered at the peak of bull markets but what about their application with respect to bear markets?

While every market cycle differs in terms of the specifics of the situation, the underlying influences can have similarities. A well-cited study performed by two finance professors from the University of Chicago found that financial markets are always vulnerable to what they called a liquidity shock — a sudden tightening of credit. These liquidity shocks have happened before and are likely to happen again. The 1991 recession is a recent example of a liquidity shock, where lenders shifted suddenly from easy credit standards to extremely tight credit standards.

Predicting these liquidity shocks with certainty is extremely difficult – there is always a small but significant chance that one could happen at any time. Investors need to factor this risk into their investment strategy. Admittedly, this is perhaps of little comfort for investors who are in the midst of the current credit crisis.

But what should be factored into your investment strategy to cater for these times?

Firstly, that liquidity shocks do not last forever. Predicting the end of the bear market is as difficult as predicting the top of the bull market. The study notes that liquidity shocks are so intense that the securities most vulnerable to them provide higher longer term returns to compensate investors for taking the risk. They note that even if you think the credit crisis has longer to run, out of favour investments should provide high-enough returns over the long term to make the risk worth taking. This is provided you can stand the short term volatility.

The best advice we can provide is to act as if you do not know what the market will do in the short term. Be open to any possibility and make your decisions with this level of humility, knowing that the market rewards intelligent risk taking over the longer term.

The above was based on an article that appeared in the New York Times on 27 December 2008. The full article, Yes, History Has Much to Say About This Market, can be found by clicking this link.

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