The Globe and Mail, Report on Business
Published July 11, 2009

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A lot of thought has been going into the lessons learned from the recession. That's prompted me to think about what has come out of the turmoil in the capital markets. It didn't take long to come up with a list. Here are my top five lessons learned, or should I say relearned: When it comes to markets and cycles, investors are not very good students. We seem to make the same mistakes over and over.

Leverage is a two-way street. During the years leading up to the summer of 2007, credit was available to any person, organization or investment firm that wanted it. The signs all said one way and there were no stop lights. But when debt is introduced to the mix, the range of possibilities is increased. The worst-case scenario should determine how much leverage is tolerable, but with low interest rates and a strong economy, that option wasn't being considered.

As an asset manager, it was also frustrating to see that investment returns created by leverage (and other forms of financial engineering) were being treated as equal to those based on corporate profits. While trying to temper clients' expectations, we found ourselves competing against levered products offering “potential” returns. Don't they know debt works both ways?

Don't get carried away on one theme and stray from your long-term strategy. The investors that had all their money with Bernie Madoff were extreme cases, but long cycles and past success do tend to lead people away from their long-term asset mix. Whether it was the Nifty Fifty in the 1970s, technology in the '90s or resources this time around, we're prone to getting carried away. And not just the amateurs, the pros do it too. Everyone on the buy side was watching the Ivy League schools – Harvard, Yale and Princeton – to see how they were generating such high returns, but this cycle they went overboard on illiquid investments (real estate, private equity and commodities) and got caught in a cash squeeze. I was guilty of letting my (and our clients') exposure to corporate bonds creep up after many years of good returns.

Don't assume liquidity will be there when you need it. When there is plenty of money flowing, investors start to believe it will always be there. “There is a wall of liquidity out there, the market can't go down,” was a common refrain in 2006 and 2007 when the pockets of hedge fund and private equity managers were bulging.

As I've said before, don't ever base an investment strategy on capital flows. The money tap can turn off in an instant – and without warning – which is what happened in the summer of 2007. Whether it's an individual needing money from his/her portfolio, a corporation refinancing its loans, or a structured product rolling over short-term financing, it should never be assumed that markets will be favourable, or even available, at the moment of need.

When I was a young sell-side analyst in the 1980s, I once admonished the chief financial officer of Canadian Pacific Ltd. for doing an equity issue when it didn't appear the company needed the capital. He stared at this nervy, naive punk and said, “I took it because it was there.” I didn't get his point at the time, but it eventually sunk in.

Risk management systems work until they don't. And they don't when circumstances extend beyond the range of expected outcomes. Sophisticated formulas assume that correlations are stable and distribution curves are normal. But correlations are as erratic as a driver on a cellphone and we don't need to be protected until abnormal times.

And yet, the elegance of the models is hard to resist. As managers, we get sucked into micro-managing unimportant stuff (tracking error versus the benchmark, style factors and cross-correlations) and fail to use common sense on the big stuff.

Finally, it's not different this time. It's just another episode of the same show. The economic and market cycle has not been repealed, even though former president George W. Bush and former U.S. Federal Reserve chairman Alan Greenspan tried their darnedest. Booms lead to busts, and extreme booms lead to what we have now. Therefore, price is always important, no matter how much capital is available or how compelling the story behind the investment is. And it's always better to sell when people around you are greedy and buy when they are fearful.

Not long ago we were thinking that we'd never have a recession because of “Chindia.” Now we are questioning the potential for a recovery. This is no different than any other cycle. Individuals and organizations adapt to a new set of circumstances. Inventories will be reduced, uneconomic production taken out of service, debtors delevered, and lo-and-behold, growth will reappear, from a lower, more sustainable base.

In an interview with Barron's magazine last fall, Jeremy Grantham, chairman of GMO in Boston, was asked if we will learn anything from the crisis. He answered, “We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.”

Unfortunately he's right. But let's at least commit to remembering these five lessons. Repeat after me…