How rattled were people in the heat of the 2008 financial crisis? Gibson Capital LLC founder and author Roger C. Gibson recalled being asked by three or four clients whether the S&P 500 would drop to zero. Perhaps it wasn’t a lot of people, he said, considering his practice served 100 investors; but Gibson knew that if just a few were asking about the prospect of such an extraordinary possibility, a lot more were quietly thinking about it.
“People were worried about the whole unraveling of the system,” Gibson said during a presentation Thursday in Brooklyn at the National Association of Personal Financial Advisors’ Practice Management and Investments conference. The author of “Asset Allocation: Balancing Financial Risk” (McGraw-Hill, fourth edition), Gibson spoke about working with clients during the crisis. In the weeks that followed the market collapse, he set up two sets of meetings with clients; one reviewed the state of the markets and client investments, while the other focused on behavioral issues that clients needed to understand.
There were multiple reasons why the markets fell, Gibson said, including excessive leverage, securitization, misaligned interests, and old-fashioned greed. The omission of any one of them would have produced a less damaging crisis. But what made the crisis so awful was the failure of diversification; nearly every asset class headed south, with the exception of long-term government bonds and T-bills. It’s an old adage, Gibson said: “The only thing that goes up in a panic is correlation.”
Many clients wanted to be put in cash until the crisis resolved itself, a classic investment mistake in Gibson’s view; by the time of resolution, they would have missed the gains. People often confuse their capacity for risk—that is, their ability to financially absorb losses—with their tolerance for risk, or the psychological willingness to bear it, he said. The fact that someone has the financial wherewithal to bear risk doesn’t mean they can abide a market downturn; while someone with a more cavalier attitude about the potential losses involved with investing may lack a suitably muscular portfolio that can sustain his tolerance.
The crisis caused clients to re-evaluate their risk tolerance, Gibson said. He told clients that the size of previous losses conditions their willingness to put up with future losses; risk, looking backward, is not the same as risk looking forward. In the past, bulls inevitably followed bear markets, he said, but that doesn’t mean that a client will go along for the ride, particularly after the magnitude of the 2008 crash. And client risk tolerance during the phase when portfolios are being accumulated may differ from the time when he or she is drawing down on the investments.
Gibson has seen diversification failures six times in the past 30 years. Such failures, he points out, aren’t necessarily bad things; correlations can approach 1.0 when everything in a mixed portfolio is rising, as happened in 1983, 2003, and 2009. Nobody complains when that happens, of course, but it’s still a failure of diversification. It’s when the bottom drops out for everything, as happened in 1981, 1994 and 2008, that investors want to head for the doors. Investors who overreact to short-term changes in the market, Gibson says, are no longer long-term investors.
While some say that the financial crash has shot holes in the theory of diversification, he is still a believer of multiple asset class investing. The philosophy promises to provide long-term portfolio returns that beat the weighted average return of the asset classes within the portfolio, with less volatility. But such a system doesn’t eliminate risk; it only reduces its impact. “Our clients really want us to hedge the world for them, but you can’t do it,” Gibson said.
The phrase, “It’s different this time,” has been used to justify all manner of bad investment decisions, Gibson observed, but one thing has changed of late that gives him pause. He said he is seeing more systemic risk in the system that at any time in his career. The worst of the 2008 crisis is over, but world markets and economies are in the hands of policymakers and politicians, and “It makes me feel a little extra nervous.”