Three years ago marked the beginning of what would become the worst recession on record. This so-called Great Recession was accompanied by several other disturbing events, including the following:
- A fifty percent drop in the stock market,
- Sharp declines in home values and sales,
- Bernie Madoff,
- Government bailouts,
- Rapidly growing deficits at all governmental levels, and
- Widespread loss of faith in the wisdom and practices of our nation’s largest banks.
These events changed how people view investing and wealth management. They also taught several important lessons like this one: Don’t trust old assumptions about portfolio risk.
The financial planning/investment analysis community is well known for its love of quantitative models. For years, it bragged about its ability to crunch the numbers and predict the likelihood that a given portfolio would meet client goals. With sufficiently thorough analysis, it was thought that every possibility could be anticipated…and…managed!
Unfortunately, those analyses were only as good as the assumptions and information upon which they were based. Those assumptions failed to anticipate the impact of pervasive leverage not only in the United States but also on a global scale. Think of leverage as an “outlier event”.
The end result was that even the most carefully hedged portfolios experienced extreme volatility and dramatic declines in value.
The lessons are:
- Don’t trust old assumptions.
- Investors need to beware of outlier events.
To quote a famous line from Hill Street Blues: Be careful out there!