Investment Lessons From the Financial Crisis

Like most investors, the experience of the financial crisis left an indelible mark on me as an evaluator of risk. Like most of you, I spent countless late-night hours reading, consuming the details of the crisis in real time as events unfolded. As I more intimately acquainted myself with vaguely understood terms like “credit default swap” and “collateralized debt obligation,” I vigorously directed my energies toward grasping the true scope of what was unfolding, and more important, what the official reaction would be.

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Unbeknownst to me was that experience would lead me to a completely new philosophy of counterparty risk, money, savings, wealth, and diversification. And after the immediate volatility had subsided, I did an autopsy on all my mistakes before and during the crisis, big and small. The biggest question I had to personally answer to myself is why I didn’t see it coming. At what point during that period were the warning signs so glaring that I should have been better prepared for what was approaching?

After a few years of reflection, I am convinced that I should have seen it all coming, after the failure of the auction rate preferred market. The moment when these supposedly riskless investments – often used by investors to hold short-term cash – became completely illiquid, I should have known something big was coming. What one day was considered one of the safest instruments around was the next a completely bid-free, frozen market.

To this very day — over five years later — 100 billion of those dollars are still tied up in auction rates. This blatant miss has driven me to follow current financial events, searching for that proverbial canary in the coal mine in today’s market environment.

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Mr. Market is Unfazed

Sadly, countless events are unfolding every day that in normal times would shock the markets to their very foundations, and yet today they elicit nary a yawn.
Whether it’s Japan embarking on the largest monetary stimulus in this history of civilization or Cypriots waking up one day and finding out that the bulk of their life savings is in all likelihood gone, the warning signs seem to flash brighter and brighter every day that something is wrong. The rules seem to change as quickly as the headlines. It seems risk management has become a part-time job for proactive investors around the world.

In this vein, the recent announcement regarding Dutch Bank ABN Amro’s decision that clients with gold deposits at the bank will no longer be able to take delivery of their property set off my alarm bells. Instead, all exchanges will be for cash. Refusing delivery is the ultimate form of betrayal to a gold investor. People purchase physical precious metals for many reasons; one paramount to almost all of them is the ability to use gold as a hedge against unpleasant economic outcomes… a hedge that protects value when the value of everything — including money itself — comes into question.

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Integral to the function of that hedge is the ability to take possession of your property at any time. What’s the point of being forced to settle in currency when diversification out of currencies is one of the main reasons you bought gold in the first place? We already have a readily accessible method of buying gold that only settles in cash; it’s called an exchange-traded fund.

Sophisticated investors buy the actual yellow metal because in its physical form gold cannot default and cannot be downgraded.

Originally written for the website of the Hard Assets Alliance, an industry association of trusted economic and investment research firms that fosters a better understanding of prevailing economic trends and offers investing advice. Open a SmartMetals™ investing account from Hard Assets Alliance here.

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