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Ten Time Honoured Lessons

There are ten time honoured lessons to be learned from the market declines of 2008 and early 2009.

1. Markets aren't efficient

Academics refuse to jettison the efficient market hypothesis, despite evidence of its role in the recent crisis. As the 11th Circuit Court of the United States wrote in a recent opinion, "All bubbles eventually burst, as this one did. The bigger the bubble, the bigger the pop. The bigger the pop, the bigger the losses."

2. Relative performance is a dangerous game

Like the efficient market hypothesis, its offspring the capital asset pricing model also rests on flawed assumptions. It commits fund managers to relative performance rather than absolute performance, which leads them to follow market weightings when picking stocks rather than their own good ideas.

3. The time is never different

Bubbles are identifiable before they burst, and knowledge of the history of bubbles can help preserve capital. Each bubble inflates and bursts in five phases, identified by John Stuart Mill in 1867: Displacement, credit creation, euphoria, financial distress and revulsion.

4. Valuation matters

The principles of value investing tell us to buy when the market is cheap and sell when the market is expensive. This means, however, that we must be prepared to not be fully invested when equity prices are unattractive.

5. Wait for the fat pitch

The average holding period for a stock on the New York Stock Exchange is six months. This myopia creates opportunities for investors who are willing or able to act on a longer time horizon and wait for the "fat pitch" - the time when valuation figures are just right.

6. Sentiment matters

Market sentiment swings like a pendulum from irrational exuberance to despair. It therefore pays to be a contrarian investor. Young, volatile, unprofitable "junk" firms generate the best returns when sentiment is low. Mature, low volatility, profitable "quality" firms produce the best results when sentiment is high.

7. Leverage can't make a bad investment good, but it can make a good investment bad!

Adding leverage onto an investment with small returns doesn't turn it into a good idea. Leverage can limit staying power, and can turn temporary impairment into a permanent impairment of capital. "Financial innovation" is usually just thinly veiled leverage.

8. Over-quantification hides a real risk

Risk is not volatility. Rather, risk is the permanent loss of capital. We would be better off abandoning our obsession with measurement and instead focus on the three main paths to permanent loss of capital: Valuation risk (buying an overvalued asset), business risk (fundamental problems) and financing risk (leverage).

9. Macro matters

Ignoring the top-down view of the markets can be incredibly expensive. The credit crisis showed precisely how a top-down view of the markets can inform and enrich a bottom-up perspective. Investors who understood the impact of the bursting of the bubble avoided financials, while those who focused on the bottom-up saw cheapness, but missed the value trap resulting from the bursting credit bubble.

10. Look for sources of cheap insurance

Insurance is often a neglected asset. Insurance virtually guarantees short-term losses, but also provides a big payout if an event occurs. It is best to avoid purchasing insurance right after an event occurs, because that is when it is most expensive.

Attribution: This article is a synopsis of a white paper by James Montier, a member of the GMO asset allocation team. It is reproduced with permission from Advisor Perspectives.

Reproduced with permission from financial alert.

© 2010 financialalert, Brillient Investment Publishing Pty Ltd ABN 19 122 531 337.

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