How to Survive the Next Stock Market Crisis

Note: I am not predicting a stock market crisis in the near term. But what follows below is a discussion on how an investor can survive a crisis that will certainly happen at some time in the future. That’s the nature of financial markets, you see.

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“Hey Vishal, how are you doing today?” asked my friend Ravi as we met for lunch last weekend.

“I’m good, Ravi. How have you been?”

“Super, and more excited than ever!” he replied.

“Glad to know that,” I said. “You got a promotion at the job?”

“No, I’m excited for another reason.”

“Bull market?” I asked, almost knowing what was coming next.

“Yeah, yeah, you guessed it right this time!” Ravi exclaimed. His joy seemed to know no bounds.

“I just sold a five-bagger from my portfolio,” he said with great pride, “And three more stocks are almost hitting that level.”

“Great to know that Ravi. The last time I saw you this happy was in 2007.”

“Oh, don’t be a sadist Vishal,” Ravi said. “Don’t remind me of what happened then.”

“No Ravi, please don’t get me wrong! It just struck me that I saw you so happy only so many years back.”

“Yeah Vishal, and all my happiness and savings were destroyed in the 2008 crash. You remember that or not?”

“I do, my friend.”

“But you survived the 2008 crash, right?” Ravi asked.

“Yes, my friend. I survived it by the skin of my hair.”

“I know you have told me this before,” Ravi said, “But just to refresh my memory, how did you survive then?”

“I sold all my stocks, except one, and almost all my equity funds before the markets tanked in 2008,” I replied. “In fact, when the capitulation happened in stocks after Lehman collapsed in September 2008, I was just a bystander.”

“Wow, you had the foresight of the coming crash?”

“Not really, Ravi! It was more due to luck than any skill or foresight on my part.”

“How Vishal?” Ravi asked. “Sorry, I even forgot this story of yours.”

“Well, the reason I sold my stocks and equity fund investments then was due to a need that I had created for myself – the need to prepay half of my housing loan using the investments I had created till then. Something I had promised my wife when I was taking on the loan in 2006 – that I would repay all of it in less than five years.”

“Oh, then I must credit your wife for saving you from that crisis,” Ravi said with a smile on his face.

“Indeed, you must. I had made that promise to my wife in a moment of “showing off,” but I was still able to meet it. In fact, in five years, i.e., by 2011, I was debt free.”

“That is when you had quit your job, right?”

“Yes Ravi. Anyways, coming back to my antics of selling almost all my equity and thereby surviving the 2008 crisis, I won’t mind if you attribute it to a great amount of good luck – and of course my wife – instead of my skill in predicting the capitulation.”

“In hindsight, that sounds good Vishal. But is there a way, outside of luck, that an investor can survive a bad market that succeeds good times?”

“Well, it’s great to know Ravi that you know something about reversion to the mean,” I said, “That is, a bad market succeeds a good market, and vice versa. But I think there are ways an investor can survive such bad markets that succeed good markets.”

“Can you please explain?” Ravi asked.

“Look at history here,” I said. “In fact, I suggest you read this wonderful book by John Kenneth Galbraith titled A Short History of Financial Euphoria. In this book, the author explains how people often lapse into financial dementia, that is, they often forget that when it comes to financial markets, history repeats itself. And that causes them to take dumb risks the next time their fellow participants are on a high as asset prices are surging.

“The author also suggests that the one constant which can be taken for granted is that speculative insanity and its associated financial devastation will reliably recur. So, you can be sure that we will have a period of wealth destruction after every period of euphoria when investors, individuals or institutions, are captured by the wondrous satisfaction from the wealth they have accrued in the recent past.”

“You are scaring me, Vishal. You always do!”

“No Ravi, I am just trying to guide you to the way you can survive a bad market that succeeds heady times.”

“Where?” Ravi asked. “All you have done till now is tell me the history of what has already happened. What about the future, Vishal?”

“I am coming to that only, Ravi. You see, the reason I am talking about Galbraith’s book and history is because knowing what has transpired in the past has great practical value for your future as an investor.”

“But how?” Ravi asked, now visibly uncomfortable and irritated.

“Because, to quote Mark Twain, history doesn’t repeat itself but it often rhymes. And this is especially true of the financial markets. Each time you may have different reasons for prices of stocks or other assets to surge, but the patterns they follow is nearly the same.”

“Now, do you want to know about this pattern, Ravi?” I asked.

“Of course, I do Vishal! You cannot leave me midway!”

“Then listen carefully, for this may help you. The first stage of any financial euphoria is when something catches the fancy of people because it may have risen in price in recent times. Like it was the case with Tulips in Holland in the 1630s, the South Sea Company in England in the 1700s, dot-com stocks in 2000, and infra stocks and complex derivatives in 2006 and 2007.

“Then, in the second stage, because the price of this object or “next big thing” has gone up in the recent past, and some people have minted money on it, it attracts new buyers to the market. This ensures a further increase in prices. So, it becomes a cycle, which looks virtuous till it is shattered. An object’s price increases, which attracts new buyers, which causes further increase in the price.”

“So, this is what is happening now in small and mid-cap stocks, right Vishal?” Ravi broke his silence.

“Sort of,” I replied. “And this is where the fun begins. While the cycle of new buyers causing prices to keep rising is moving, no one – especially those who joined the game just because the prices were rising – is willing to believe that a large part of the wealth thus created is undeserved – largely a result of luck not their skill.

“As Galbraith writes this in his book – ‘Those involved with the speculation are experiencing an increase in wealth – getting rich or being further enriched. No one wishes to believe that this is fortuitous or undeserved; all wish to think that it is the result of their own superior insight or intuition. The very increase in values thus captures the thoughts and minds of those being rewarded. Speculation buys up, in a very practical way, the intelligence of those involved.’”

“Wow Vishal, I can so much relate to that last statement of Mr. Galbraith that speculation buys up the intelligence of those involved. I can see this happening around me and, to be frank with you, often to me.”

“I can also sense that, Ravi. But wait, Galbraith is not saying that all invested in such situations or in assets whose prices are surging are speculating. What he just described above is especially true of those who are convinced that prices are going up permanently and indefinitely. These are also the guys who, in such times, would ignore or condemn the skeptics because they believe they are in complete control of the asset prices and consider themselves as geniuses. But then, as Galbraith also says that it is such people who rediscover the oldest rule of the markets, and that is – Financial genius is before the fall.”

“But Vishal, how can one know when that fall actually comes?”

“That’s a good question, Ravi. Galbraith writes in his book, ‘…built into this situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster. Something, it matters little what – although it will always be much debated – triggers the ultimate reversal. Those who had been riding the upward wave decide now is the time to get out. Those who thought the increase would be forever find their illusion destroyed abruptly and they, also, respond to the newly revealed reality by selling or trying to sell. Thus the collapse. And thus the rule, supported by the experience of centuries: the speculative episode always ends not with a whimper but with a bang.’”

“Yeah, like it happened in 2008,” Ravi said. “It was indeed a big big bang!”

“Right Ravi.”

“So Vishal, what’s your prediction for the next 2008-like crash? Is it coming soon?”

“I don’t know that, Ravi, and so I have no answer to your questions. In fact, no one knows, and anyone who presumes the answer does not know he does not know. But one thing is certain, which I can gauge from reading Galbraith and other authors who have captured financial history – there will be another of such episodes when asset prices capitulate and there is widespread wealth destruction.”

“Agreed. But how does one protect against such an eventuality?”

“Ravi, here I am reminded of what a wise man once said. A fool and his money are soon parted. And so, alas, are those who, responding to a general mood of optimism all around, are captured by a sense of their own financial acumen.

“Galbraith advises, ‘…when a mood of excitement pervades a market or surrounds an investment prospect, when there is unique opportunity based on special foresight, it is the time for caution. Perhaps, indeed, there is opportunity. Maybe there is that treasure on the floor of the Red Sea. A rich history provides proof, however, that, as often or more often, there is only delusion and self-delusion.’”

“In simpler words, during such periods of enhanced optimism, Galbraith advises enhanced skepticism. One that associates too much optimism with foolishness and does not equate intelligence with quick wealth creation.”

“So, in short, you are calling me a fool, right?” Ravi quipped.

“No, I am asking you to not equate your recent quick stock market riches with any little intelligence you may have,” I replied, as we ended the discussion with a hearty laughter.