Via Value Investor Insight
In this excerpt from his annual letter, investing great Seth Klarman
describes 20 lessons from the financial crisis which, he says, “were
either never learned or else were immediately forgotten by most market
participants.”

One might have expected that the near-death experience of
most investors in 2008 would generate valuable lessons for the future.
We all know about the “depression mentality” of our parents and
grandparents who lived through the Great Depression. Memories of tough
times colored their behavior for more than a generation, leading to
limited risk taking and a sustainable base for healthy growth. Yet one
year after the 2008 collapse, investors have returned to shockingly
speculative behavior. One state investment board recently adopted a
plan to leverage its portfolio – specifically its government and
high-grade bond holdings – in an amount that could grow to 20% of its
assets over the next three years. No one who was paying attention in
2008 would possibly think this is a good idea.

Below, we highlight the lessons that we believe could and should have
been learned from the turmoil of 2008. Some of them are unique to the
2008 melt- down; others, which could have been drawn from general
market observation over the past several decades, were certainly
reinforced last year. Shockingly, virtually all of these lessons were
either never learned or else were immediately forgotten by most market
participants.

Twenty Investment Lessons of 2008

1. Things that have never happened before are bound to occur with
   some regularity. You must always be prepared for the unexpected,
   including sudden, sharp downward swings in markets and the economy.
   Whatever adverse scenario you can contemplate, reality can be far worse.
2. When excesses such as lax lending standards become widespread and
   persist for some time, people are lulled into a false sense of
   security, creating an even more dangerous situation. In some cases,
   excesses migrate beyond regional or national borders, raising the ante
   for investors and governments. These excesses will eventually end,
   triggering a crisis at least in proportion to the degree of the
   excesses. Correlations between asset classes may be surprisingly high
   when leverage rapidly unwinds.
3. Nowhere does it say that investors should strive to make every last
   dollar of potential profit; consideration of risk must never take a
   backseat to return. Conservative positioning entering a crisis is
   crucial: it enables one to maintain long-term oriented, clear thinking,
   and to focus on new opportunities while others are distracted or even
   forced to sell. Portfolio hedges must be in place before a crisis hits.
   One cannot reliably or affordably increase or replace hedges that are
   rolling off during a financial crisis.
4. Risk is not inherent in an investment; it is always relative to the
   price paid. Uncertainty is not the same as risk. Indeed, when great
   uncertainty – such as in the fall of 2008 – drives securities prices to
   especially low levels, they often become less risky investments.
5. Do not trust financial market risk models. Reality is always too
   complex to be accurately modeled. Attention to risk must be a 24/7/365
   obsession, with people – not computers – assessing and reassessing the
   risk environment in real time. Despite the predilection of some
   analysts to model the financial markets using sophisticated
   mathematics, the markets are governed by behavioral science, not
   physical science.
6. Do not accept principal risk while investing short-term cash: the
   greedy effort to earn a few extra basis points of yield inevitably
   leads to the incurrence of greater risk, which increases the likelihood
   of losses and severe illiquidity at precisely the moment when cash is
   needed to cover expenses, to meet commitments, or to make compelling
   long-term investments.
7. The latest trade of a security creates a dangerous illusion that
   its market price approximates its true value. This mirage is especially
   dangerous during periods of market exuberance. The concept of “private
   market value” as an anchor to the proper valuation of a business can
   also be greatly skewed during ebullient times and should always be
   considered with a healthy degree of skepticism.
8. A broad and flexible investment approach is essential during a
   crisis. Opportunities can be vast, ephemeral, and dispersed through
   various sectors and markets. Rigid silos can be an enormous
   disadvantage at such times.
9. You must buy on the way down. There is far more volume on the way
   down than on the way back up, and far less competition among buyers. It
   is almost always better to be too early than too late, but you must be
   prepared for price markdowns on what you buy.
10. Financial innovation can be highly dangerous, though almost no one
    will tell you this. New financial products are typically created for
    sunny days and are almost never stress-tested for stormy weather.
    Securitization is an area that almost perfectly fits this description;
    markets for securitized assets such as subprime mortgages completely
    collapsed in 2008 and have not fully recovered. Ironically, the
    government is eager to restore the securitization markets back to their
    pre-collapse stature.
11. Ratings agencies are highly conflicted, unimaginative dupes. They
    are blissfully unaware of adverse selection and moral hazard. Investors
    should never trust them.
12. Be sure that you are well compensated for illiquidity – especially
    illiquidity without control – because it can create particularly high
    opportunity costs.
13. At equal returns, public investments are generally superior to
    private investments not only because they are more liquid but also
    because amidst distress, public markets are more likely than private
    ones to offer attractive opportunities to average down.
14. Beware leverage in all its forms. Borrowers – individual,
    corporate, or government – should always match fund their liabilities
    against the duration of their assets. Borrowers must always remember
    that capital markets can be extremely fickle, and that it is never safe
    to assume a maturing loan can be rolled over. Even if you are
    unleveraged, the leverage employed by others can drive dramatic price
    and valuation swings; sudden unavailability of leverage in the economy
    may trigger an economic downturn.
15. Many LBOs are man-made disasters. When the price paid is excessive,
    the equity portion of an LBO is really an out-of-the-money call option.
    Many fiduciaries placed large amounts of the capital under their
    stewardship into such options in 2006 and 2007.
16. Financial stocks are particularly risky. Banking, in particular, is
    a highly leveraged, extremely competitive, and challenging business. A
    major European bank recently announced the goal of achieving a 20%
    return on equity (ROE) within several years. Unfortunately, ROE is
    highly dependent on absolute yields, yield spreads, maintaining
    adequate loan loss reserves, and the amount of leverage used. What is
    the bank’s management to do if it cannot readily get to 20%? Leverage
    up? Hold riskier assets? Ignore the risk of loss? In some ways, for a
    major financial institution even to have a ROE goal is to court
    disaster.
17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
18. When a government official says a problem has been “contained,” pay no attention.
19. The government – the ultimate short-term-oriented player – cannot
    withstand much pain in the economy or the financial markets. Bailouts
    and rescues are likely to occur, though not with sufficient
    predictability for investors to comfortably take advantage. The
    government will take enormous risks in such interventions, especially
    if the expenses can be conveniently deferred to the future. Some of the
    price-tag is in the form of back- stops and guarantees, whose cost is
    almost impossible to determine.
20. Almost no one will accept responsibility for his or her role in
    precipitating a crisis: not leveraged speculators, not willfully blind
    leaders of financial institutions, and certainly not regulators,
    government officials, ratings agencies or politicians.

Below, we itemize some of the quite different lessons investors
seem to have learned as of late 2009 – false lessons, we believe. To
not only learn but also effectively implement investment lessons
requires a disciplined, often contrary, and long-term-oriented
investment approach. It requires a resolute focus on risk aversion
rather than maximizing immediate returns, as well as an understanding
of history, a sense of financial market cycles, and, at times,
extraordinary patience.

False Lessons

1. There are no long-term lessons – ever.
2. Bad things happen, but really bad things do not. Do buy the dips,
   especially the lowest quality securities when they come under pressure,
   because declines will quickly be reversed.
3. There is no amount of bad news that the markets cannot see past.
4. If you’ve just stared into the abyss, quickly forget it: the lessons of history can only hold you back.
5. Excess capacity in people, machines, or property will be quickly absorbed.
6. Markets need not be in sync with one another. Simultaneously, the
   bond market can be priced for sustained tough times, the equity market
   for a strong recovery, and gold for high inflation. Such an apparent
   disconnect is indefinitely sustainable.
7. In a crisis, stocks of financial companies are great investments,
   because the tide is bound to turn. Massive losses on bad loans and
   soured investments are irrelevant to value; improving trends and future
   prospects are what matter, regardless of whether profits will have to
   be used to cover loan losses and equity shortfalls for years to come.
8. The government can reasonably rely on debt ratings when it forms
   programs to lend money to buyers of otherwise unattractive debt
   instruments.
9. The government can indefinitely control both short-term and long-term interest rates.
10. The government can always rescue the markets or interfere with
    contract law whenever it deems convenient with little or no apparent
    cost. (Investors believe this now and, worse still, the government
    believes it as well. We are probably doomed to a lasting legacy of
    government tampering with financial markets and the economy, which is
    likely to create the mother of all moral hazards. The government is
    blissfully unaware of the wisdom of Friedrich Hayek: “The curious task
    of economics is to demonstrate to men how little they really know about
    what they imagine they can design.”)