Wednesday, December 31, 2008

The Crisis of 2008: Lessons learned, unlearned and reinforced

The one thing I can say about 2008 was this it was not boring. I know that there will be a flood of books coming out over the next few months telling us what happened, why it happened and most important of all, who to blame. I don't think that they will tell us much that we don't know already.  I have a different book in mind and this is what I want to do. I want to look inward and ask myself what I have learned from these last few weeks that I can incorporate into my "view of the world" looking forward. I The market collapse and investor reaction has been a humbling experience and has revealed how much I do not know or fully understand about finance.  Here is my initial list:

Things that I know now that I did not know on September 12....
  1. Nominal interest rates can become negative.
  2. There is no riskfree asset.
  3. Equity risk premiums can change dramatically even in mature markets.

Things that I thought I knew on September 12, that I am not so sure about now...
  1. Large companies in developed markets can always raise new capital.
  2. Bank runs are things of the past, with the regulatory oversight, accounting rules (mark to market) and risk management tools that we have today.
  3. Value investing (investing in low PE , high dividend yield and low PBV stocks) is less risky than growth investing.
  4. Dividends are sticky.
  5. Diversification across asset classes provides protection.
Things that I kind of knew on September 12 that have been reinforced since....
  1. Debt is a double edged sword. (The costs and likelihood of distress can be much higher than I thought...)
  2. A large cash balance is not just a wasting asset but protection against danger.
  3. The line between hedging and speculation is a very fine one... and easy to cross...
  4. Main Street and Wall Street are co-dependent. One cannot be healthy, if the other is not.
  5. We are in a global economy.
  6. Ignore illiquidity at your own peril.... Its cost can vary across time and across markets
  7. Risk is not just a number.
  8. Stocks don't always win in the long term.
  9. Smart money is not that smart!!! 
  10. Even great investors make mistakes! 
In fact, I have been collecting ammunition for each of these points, by scouring news stories from the the last three months. Sometime over the next year, I will sit down and start putting it down on paper. All I need is a good title!

24 comments:

Heshrulz said...

"I know that there will be a flood of books coming out over the next few months"

I guess we are already flooded with enough post-mortem books on the crisis.None worse than "Panic" supposedly edited by Michael Lewis! Its a collection of old articles written by eminent people!!! This is his second on the trot after "The real price of everything" where he tried to sell us the copy paste edition of the work of great economists of the world.

I am glad that you are thinking of a book on your own experience rather than a half-cooked prescriptive one on how the world should work!

Apurv said...

I give u a title.
Hope u might Find it useful
---"Tough Nuts"

Davide said...

a bit of a cheesy title suggestion: 'finance wonderland'

Donald Lee said...

"Unlimited latitude of bubbles"

After observing all of these recent meltdowns and its successive dismals, maybe these bubbles and rendering down may not only be restricted to economy or business. It may apply to every aspect of our lives, and even those things that we don’t even attempt to reckon at, such as love.

Donald Lee said...

Business and finance is an ongoing process of bubbles and either hard or soft landing. Maybe we should try to make this "organic" financial system less vulnerable from the unlimited and destroying power the bubble has. That's the reason why I think maybe the title I've listed above could be a good(?) candidate for your new book, since nobody, including yourself as you just posted at your article,have gotten to know new facts, and I think this all came from the unlimited latitude of the bubbles.

Sudeep said...

Three good articles on Nytimes.com for financial lessons of 2008:

1. http://www.nytimes.com/2009/01/04/opinion/04lewiseinhorn.html?em=&pagewanted=all

2. http://www.nytimes.com/2009/01/04/opinion/04lewiseinhornb.html?pagewanted=all

3. http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?ref=magazine&pagewanted=all

Deepak Krishnan said...

Some doubts..

while doing analysis of a company's capital structure there can be a scenario , where a company is under leveraged. Academicians suggest that in order to reduce WACC, it is better for this company to have more debt.

As an academician will you hold the same opinion under the current credit crisis ?

Aswath Damodaran said...

Only academics? Any sensible person would note that if there is a way to reduce your overall cost of capital by changing your mix of debt and equity, you should do it. This crisis may lead us to reevaluate the costs and benefits of debt, but the principle still stands.

tunck. said...

How about;

"The Crisis of 2008: Broken by heart"

Lincoln Minor said...

"The New New Known Unknowns" is a title that would play off a previous Michael Lewis title ("The New New Thing"); get the word "new" in there twice (always good for the marketing folks); use a phrase ("known unknowns") popularized by Donald Rumsfeld in 2002 and referred to over the ensuing years in value investing circles; and reflect your concept of self-inspection as to what you learned during the 2008 financial crisis.

andras.puskas said...

Is the CAPM still valid?

In my admittedly non-academic understanding of the Capital Asset Pricing Model, one of the key assumptions is that asset classes are uncorrelated to a large degree. The past year the value of most asset classes has fallen. One could argue that whilst the asset classes themselves might be uncorrelated, the actions of those holders of assets that contributed most to the pricing of those assets, i.e. the hedge funds, were not. They had to sell all asset classes at the same time to return money to the investors, thereby depressing the prices. If this argument were correct, of which I am not entirely certain, then a key assumption of the CAPM would be invalid and thus possibly the CAPM itself and with it the concept of diversification.

What is your opinion?

Теймураз Теймуразович Вашакмадзе said...

Did you know before crisis that
equity researchers were trying to give proof of high prices of Russian companies before financial crisis by calculating lower WACC than it was in reality?

Теймураз Теймуразович Вашакмадзе said...

Did you know that equity researchers were trying to give proof of high prices of Russian companies before financial crisis by calculating lower WACC than it was in reality?
Probably in other emerging markets as well.
I wrote and article "Calculating equity risk premium for Russian market – an empirical analysis"
http://www.scholararticles.net/article/15
Your thoughts will be interesting if you could wrute them on my blog:
http://teimuraz-valuation.blogspot.com/2008/12/blog-post_24.html

Kannan said...

Prof,

This is too early to fix a titile..wait for few more month for the new events to unfold. You will get a great title.:)

Jean Marc said...

Dear Professor Damodaran,

Your comments about "things we thought we knew and are not quite sure about it now" remind me of the arguments of Benoît Mandelbrot and Richard L. Hudson in "The (Mis)behaviour of Markets: A Fractal view of Risk, Ruin and Reward" and re-hashed and anecdotically exemplified by Nassim Nicholas Taleb in "Fooled by Randomness" and "The Black Swan".
Basically their argument is that a massive part of today's "modern" finance theory is based on the assumptions that asset price changes follow a Gaussian or "normal" distribution. Although this is very handy for building a model for its very practical mathematical properties, an analysis of practically any asset price behaviour over time shows that this is far from being the case. Rather, they argue, price changes follow a power law (and this CAN be observed in the REAL world). The effect of using the wrong distribution to gauge risk is that we are grossly underestimating risk - we just have to make a survey asking i.e. options trader (these are especially exposed to market risk) if they really use Black and Scholes or the Binomial model, and evidence will show that most of them use "modified" versions of it, "skewed" models or "propietary" models that are not even close to it, to "adjust" to how things "really work".

As Taleb puts it, there are two kinds of risk: known risk (it is impossible to know with certainty which number will come out when throwing a dice, but we know that any one number has a 1/6 probability) and unknow risk (who told you the dice is perfectly balanced in the first place? = one just "assumed" a probability distribution because it is so convenient).

Prof. Damodaran, do you think that we have to rethink Finance from the very basics (as in assuming that price changes DO NOT follow a Gaussian distribution)?

Kind regards,

JMD
Barcelona, Spain.

Dr Sameer said...

I have written about my understanding of the recession. Please correct me where I am wrong or where there is scope for improvement.
http://drsameerkulkarni.blogspot.com/2009/01/recession.html

Krishnakumar said...

Professor
you mentioned in investing in low P/B and P?E stocks is safer than "growth" stocks.

is it necessary to know the "intrinsic value" of the stock before investing or just low enough ratios are good enough.

evaluating the intrinsic worth Buffett style would give more sound value of the company's stock price - I agree

I am new to corp finance and have just started with your "investment valuation" book and have a long way to go

my fear is i would miss the cheap valuations of great companies that Buffett has invested in the past - like COP, before I get comfortable with all the valuation techniques in the text book

any advice or thoughts ?

Senith said...

I am delighted to find your blog and will follow this actively! Thank you for sharing your thoughts with us!

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Game Gratis said...

I know that there will be a flood of books coming out over the next few months"

I guess we are already flooded with enough post-mortem books on the crisis.None worse than "Panic" supposedly edited by Michael Lewis! Its a collection of old articles written by eminent people!!! This is his second on the trot after "The real price of everything" where he tried to sell us the copy paste edition of the work of great economists of the world.

Software said...

Some doubts..

while doing analysis of a company's capital structure there can be a scenario , where a company is under leveraged. Academicians suggest that in order to reduce WACC, it is better for this company to have more debt.

As an academician will you hold the same opinion under the current credit crisis ?