What Can We Learn From Past Financial Crises?

Those who do not remember the past are condemned to repeat it.”

-Benjamin Graham, The Intelligent Investor

There are precious lessons that we can learn from history. By delving into the past, we hope to be wiser and better prepared for the future.

United States Federal Reserve chairman Janet Yellen recently warned not to forget the damage caused by the last financial crisis in 2008. Although she was probably referring to policy makers, retail investors should also take heed of this warning.

With that in mind, let’s take a look at two past major financial crises, and pick up some valuable lessons.

In recent history, the major financial crises have involved either a plunge in the stock market, a huge devaluation of a currency, or a major problem with a financial institution. So the first thing we will do is to take note of what caused the crisis in the first place and what we can learn from each one.

2008 financial crisis

The inklings of a crisis started in 2007 when subprime mortgage market in the US was uncovered. Low interest rates had led to investors scrambling to find greater yield on their investment, which in turn led to overpriced assets. This eventually led to a massive collapse of the stock market, the collapse of Lehman Brothers and bailouts of international banks.

One of the main precipitating reasons for the crisis was a high default rate in the United States subprime home mortgage sector. In essence, many people were borrowing money they could not afford to pay back, especially if the asset they purchased with the borrowed money declined in value. As more and more people defaulted on the loan, the situation spiraled downwards and home prices started to decline, which exacerbated the situation.

This is just one of the reasons for this huge financial crisis of 2008 that we now know off as the global financial crisis. There are many lessons that banks and governments can learn from their mistakes of the past. However, as individual investors, there are also some takeaways to be learnt from the crisis.

The first is not to over-leverage and take on too much debt, even if interest rates are low and asset prices seem to be going up. Thankfully, in Singapore, there are certain laws to prevent investors from taking on too much debt such as the total debt-servicing ratio. This law limits the amount you can borrow based on your monthly income.

The second lesson to learn is that, we should always have cash in hand for a rainy day. This is useful to tide us through difficult times and also to take advantage of any investing opportunity such as this one.

The Dot Com Bubble (1999)

The end of the 20th century saw a huge increase in the usage of the Internet as more people were beginning to own computers at home. Investors were starting to realize the immense potential of internet-based companies. However, as investors scrambled to get a piece of the action, by buying stocks of internet based companies, stock prices began to soar way beyond what was considered normal.

To put this into perspective, the NASDAQ composite reached a price to earnings ratio of 200, way beyond its historical average of 30. This was mainly because of speculation that companies, despite current low earnings or even losses could make use of the Internet and other emerging technologies in the near future to boost earnings many times over. However, this was not to last, and as investors realized that, share prices started to drop back to something more reasonable. However, many investors were burnt during this massive bubble. Since then, some of the stocks have recovered and even surpassed their dot-com-bubble prices but many other companies failed and closed down.

As individual investors there are many things to learn from this dot-com bubble. The first is that speculation can lead to very painful experiences in the stock market. Speculators in the Dot-com bubble were putting their hopes on any tech company related to the Internet, some of which were poorly managed or had no profits. Obviously many of the speculators ended up losing a lot of money as the stocks of these companies came down and some eventually closed down completely.

The second takeaway is valuation is important. No matter how fast growing or fundamentally sound a company is, we must always go back to the basic fundamentals of valuation and never pay beyond what is a fair value.

The Foolish Bottom Line

Financial crisis are bound to occur due to greed, government’s short-term policies or misinformation. However we should take each financial crisis as a learning experience and try to avoid any mistakes that were made during that time. This will help us become better investors in the future.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.