Wednesday, October 01, 2008

Weapons of Wealth Destruction

The Financial Crisis of 2008 is the culmination of many factors since the late 1990s. To me, there seem to be consistent elements in many financial crises since 1998. I characterize these elements as the Weapons of Wealth Destruction, which have negatively impacted many companies and individuals in the past decade. Hopefully, being aware of these elements will help me avoid making some of the mistakes that can destroy our wealth.

Here's my list of the Weapons of Wealth Destruction:

  • Lack of Knowledge - It seems many people and companies did not understand the specifics of their financial decisions. From signing mortgage papers to buying CDOs, many people did not take to effort to better understand the documents and transactions to which they were committing. Since "everyone else was doing it," there appeared to be safety in numbers...how could so many people be wrong?

    I like to stick to time tested financial approaches for most of my transactions. We use 15 to 30 year fixed mortgages, invest in FDIC insured CDs, buy only top rated municipal bonds and top quality stocks. These tend to be more basic transactions which I have a better chance of understanding, and therefore have less chance of losing money in an unexpected way.


  • Underestimating Risk - People often consider mostly the upside and seem to forget the downside possibilities. There were times people thought money could only be made, and not lost, in tech stocks, real estate, investing in their own companies (e.g Enron), or over concentrating a portfolio. As a result, a larger proportion of funds may have been allocated, or more debt may have been taken than would normally be done for a higher risk option.

    Here are two simple checks I use to determine if I am underestimating risk. First, if it sounds too good to be true, then the risk is probably much higher. An example may be qualifying for a much larger mortgage when one's income hasn't changed. Second, if success requires near perfection, I know the risk is likely higher. For example, few stocks can continue going up 50% a year for the long term.

    Our main underestimated risk is the 50% proportion that is invested in company stock. It has been somewhat difficult to diversify during the bear market in 2008. Fortunately for us, my company stock has declined only 1/6 as much as the market and is only down 5% from its all time high reached in December, 2007. However, I still hope to reduce the proportion to less than 30% of our savings during 2009.


  • Over Leverage - Leverage is the two edged sword that brought down several financial companies. The 30:1 leverage used by investment banks was extremely high. While the markets were bullish, leverage helped them make extraordinary profits. However, when the downturn occurred, leverage also caused losses to occur much faster.

    In our case, we don't borrow for investments and the only debt we have is the mortgage on our house.
  • Even though we have avoided these elements, our investments have still dropped significantly in 2008. I hate to imagine what would have happened if one or more of these elements were working against us in addition to the market decline.

    For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

    This is not financial advice. Please consult a professional advisor.

    Copyright © 2008 Achievement Catalyst, LLC

    1 comment:

    Lacey said...

    This was a great post! There is so much turbulence in the market today, and people need peace of mind more than ever. I wanted to offer your readers a link to another blogger who is doing great work. He writes about our 'childhood money messages' and how the best approach to stability in today's market is to resist letting these emotions control our buying/selling habits. It is really fascinating work, and something you should all check out. His name is Spencer Sherman, and you can view his blog at http://www.curemoneymadness.com/blog.