What to Make of the Current US Financial Crisis

What to Make of the Current US Financial Crisis

A lot of people are probably worried about the current US financial crisis. When even giants like Lehman Brothers and AIG fall, what financial institution is safe? Never has the US financial sector seen one financial institution fail (Lehman brothers declares bankruptcy), another bought out (Merrill Lynch sold to Bank of America), and another taken over by the government (AIG receives US$85 billion cash infusion from the Federal Reserve, in exchange for 80% control) within the space of one week. It seems no financial institution, regardless of size, is immune from the ongoing turmoil. Understandably, a lot of investors are very worried right now.

What should investors do?

Most importantly, stay calm and do not panic. If you are a unit trust investor, you are likely already diversified and reasonably well protected against the type of individual company risk that stock investing entails. Fund managers hold dozens of stocks in their portfolio, and the maximum exposure to any one stock is capped at 10% (most of the time, it is far less). Thus, even if the fund manager is holding AIG or Lehman Brothers, the actual impact to the portfolio is small. If you were an individual investor with a small number of stocks, you would be a lot more worried about one of your holdings going bankrupt. Unless you have a stock portfolio with dozens of stocks like that of a fund manager, you stand to lose far more.

Another reason to stay calm is that by panicking and selling out now, you will be making the oldest mistake in the book ­-- buying high and selling low.

Given the current environment, market prices are low based on fundamentals and valuations. Selling now not only realises losses, but more importantly, impacts you emotionally, and the temptation will be to give up on the market, believing that the only way forward is down.

In the short term, this may or may not be true. But the consequence of such a belief is that even when the bottom is truly reached (or passed), you would not dare get back into the market. So waiting for the bottom is futile simply because investors that give up on the market will rarely jump in now matter how low or attractive markets are.

For example, the STI index is currently trading between 2400 to 2500. If you believe it will go much lower, how low is low enough? If it drops to 2000 points subsequently, you will then say “it must drop further to 1500”. If it recovers to 2700, you will say “this is a bear rally, it will fall back down to 2000”.

By holding such a belief, regardless of whether markets move up or down, you will not be convinced to re-enter the market. Even when the bottom has passed and markets are recovering, you will still be convinced that it is a temporary bear rally.

On the other hand, the investors that stay calm and stay invested through this difficult period will be in the market when the bottom does arrive, and will benefit from the recovery when it happens. It may not be easy, but it is doable.

The easiest way is to not focus so much on your losses or how much the market falls each day. If you are well diversified into markets, then have faith that markets will eventually recover.

For example, the current financial crisis in the US has already claimed a few very big victims. Shareholders of Freddie Mac, Fannie Mae, Lehman Brothers, Bear Stearns and AIG are now left with close to nothing. Yet, the Dow Jones Industrial Average (DJIA) and the S&P 500 from 8 September (before Lehman filed for bankruptcy) till 17 September, was down 8.8% and 7.8% respectively. Markets are much more resilient than individual companies. The only way the index level of a stock market can fall to zero is if every stock in the index goes bankrupt.

The US market, which has survived the Great Depression, and World War II, has bounced back before. Asia herself survived the Asian financial crisis. Then, a similar loss of confidence was felt across all of Asia’s financial stocks as well as the entire stock market during the crisis. However, Asian stocks bounced back even more strongly than before.

The bankruptcy of individual big names is scary and painful but survivors will come out stronger, leaner, meaner, and they represent the future of the market. When the dust eventually settles across the US financial markets, the survivors will have dominance over what remains the biggest financial market in the world. If the US loses economic and financial power over the course of this financial crisis, then Europe and Asia will step up and ascend in dominance.

We see this with Barclays PLC’s acquisition of certain profitable division of Lehman Brothers. When the dust settles and the global economy starts to recover again, there will still be a great need for financial institutions like banks, insurers, and wealth management houses.

More Failures

Our optimism doesn’t blind us to the very likely scenario of more failures going forward. But companies fail even during the good times. You can’t wait until there are no more failures before re-entering the market because there will never be this perfect situation. We can’t predict which company will be the next big failure, but we can be very sure the financial sector, as a whole, will recover.

In conclusion, the current pain of bankruptcies, selected bailouts; increased regulations and injections of liquidity into the system are all efforts to ensure the financial system does not fail. A good metaphor is applying a fiery solution to an open wound. While the pain is immediate and likely to have you screaming, it will prevent the wound from festering, and eventually, though it may leave a scar, it will eventually heal and you will bounce back again. Have faith, markets can and will recover.

Article taken from Fundsupermart.com.my! :-)