This short article addresses the difficulty of doing the right thing when a financial crisis arrives.  It examines the emotions and the behaviour of investors presented with chaotic market circumstances and explains both (i) why almost everyone loses and (ii) what it is that the survivors have in common.

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One day there will be an uncontained financial accident. Within hours credit facilities will be withdrawn, and there will be forced derivative position liquidations at organisations around the world. Modern derivatives will be the brokers’ loans of 1929, resulting in margin calls, liquidations, the evaporation of confidence, spectacular losses, a credit squeeze and financial chaos. The liquidations of assorted off-balance sheet positions will cause the realisation of big losses in many highly geared positions. This will in turn cause dramatic re-ratings of the creditworthiness of many borrowers.

The crisis will develop rapidly in the international bond markets - where corporations and western governments have borrowed cash consistently and cheaply. Borrowers whose worst excesses are currently hidden off balance sheet in the derivatives markets will find themselves insolvent, and their bonds and shares will plummet in line with their credit ratings. Oversupply of bonds from hurried sellers will drain the markets of cash and the selling of further bonds into the market will become impossible - even at distress prices for good bonds. The bondholders - pension funds, deposit takers and other collectors of the public’s surplus cash - will be drawn in, and will see that they are in no position to pay back their depositors.

Insurance companies will watch as the portfolios which back their obligations are destroyed. Their capital will be inadequate and they will suspend paying their annuity holders. Property secured lenders and banks will be standing in-line, having lent widely in the mortgage, debt and derivatives markets. Of the £600,000,000,000 of gross sterling deposits in the UK much is on relatively short periods (e.g. 30 day deposit accounts) and lent long term as mortgages on overpriced assets. Not the tiniest fraction of this amount of money can possibly be delivered by the banks in cash back to their depositors.

In 'normal' times [footnote] it does not matter if a bank's withdrawals exceed immediately available cash resources, because the bank can gather up some cash in bond and money markets [footnote]. But in a credit crunch they cannot do this. There will be queues at the bank but the doors will be shut, Argentina style.

Houses will appear on the market, as the equity rich seek to secure the cash which they regarded as their savings. But no-one will have the cash or the finance to buy them, and house prices will slump in search of a few brave buyers. Mortgage lenders will go hunting cash to stay afloat - they'll suspend new lending. The banks and building societies will increase borrowing rates, without increasing deposit rates, and they will suspend withdrawals [footnote]. Industrial businesses will face a slump in demand like they have never seen.  Unemployment will explode.

Only the debt free who have invested in super-cautious organisations and instruments will emerge with liquid assets.

Like most predictions these particularly wild ones are almost certainly wrong.  But they show a possibility which many savers are simply not aware of.  Most readers - even those who broadly agree that the future could get that bad - will smile inwardly in the confidence that they are shrewd enough and fast enough on their feet to get out at the first sign of trouble, before the storm really hits. Maybe they are in that tiny number who will achieve it, but it is unlikely. Not only is there simply not enough cash to pay out more than 1 or 2 percent of savers there are other great difficulties.

In times of crisis the marketplace makes it very difficult to act. At every stage of an implosion it introduces elements which obscure the ultimately successful line of action. Prices, for example, do not descend in an orderly straight line. Almost all the sharpest rises in the markets occur directly after the steepest falls. Market professionals have a black humour expression for these rallies. They call them ‘the dead cat bounce’.

Even a dead cat will bounce a few minutes or a few hours after the slump. People who lose 10% of their portfolio value on Monday morning, when the market phone isn't being answered, and then gain 8% on Monday afternoon, will choose to do nothing on Tuesday. While they're dithering the market will encourage inaction by greatly increasing the trading spread between buying and selling prices - leaving investors with the feeling that to trade is to be fleeced by the professionals. They will decide to hold on rather than lose another 10% of their money by selling while the prices are wide and the markets illiquid; and every time the prices narrow again they will wrongly think the worst is over and will still do nothing. Of the few with a trader's mentality almost all will be over-affected by the repeated market swings. Sucked out on the falls they will buy back in on the rally - on consistently wide spreads. Meanwhile any assets which offer protection to savers will boom in price, just to the point where they are uncomfortably - even dangerously expensive to buy.

This should be understood by all investors - but it isn't and it never will be. The market doesn't wait conveniently showing the point at which we should get out. It hangs between greed and fear. When it falls it tempts us to hold on with the prospect of recoveries which don't happen, yet it punishes us repeatedly if we start selling, with bounces which would have saved us from our loss. Bit by bit it turns the shrewdest market operator into a rabbit.

The significant majority of the tiny number who eventually succeed in such chaotic market circumstances will be those who acted before the storm broke. By the end they will have been through the mill, having endured countless hours of anguished doubt.  But aided by the initial profits they make as the storm breaks they will have been able to ignore strong but temporary market movements against them, provided of course they have the fundamental confidence in their own judgement of the process of economic unwinding. 

But even then only a handful will exit their wealth preservation strategy and go back into productive businesses within 20% of the bottom. This is what it is like to be a successful investor. Even in the good times it is painful to sell well, and painful to buy well. But during times of crisis the pain is amplified by extreme volatility, wide pricing, and thousands upon thousands of column inches of popular newspaper analysis recommending entirely the wrong action.

"Perhaps never before or since have so many people taken the measure of economic prospects and found them so favourable as in the two days following the Thursday [24th October 1929] disaster". J.K.Galbraith - The Great Crash 1929. However, "On Monday the real disaster began".

The disaster of 1929 was to continue down, then up; horror, then hope, then horror, for 6 months. It sunk the bulls, the speculators, the bottom fishers, the momentum trackers, the chartists, the value investors - everyone. Virtually no-one who had ever been involved in the markets came out of the other side with any money at all.

Perhaps the last word should be left to someone who did.

"The complexity of this era of credit liquidation is far too great for the mob mind to grasp. It is hardly possible for them to see the picture wherein about 700 billion dollars of physical and intangible wealth is attempting to be turned into about 5 billion dollars of money" Robert L Smitley writing in his usual style and with his normal regard for the intelligence of the average investor in his hugely entertaining book 'Popular Financial Delusions' - published in 1933.

By the mid 1930s investors who had lost everything started to read the words of market analysts - like Mr Smitley - who amidst the general poverty told them how predictable the crash had been. Strangely not many of them were rich. (To be fair Mr Smitley was. He made his fortune by trading in old business books on Wall Street between the wars. Apparently he read some of them as well!). We will doubtless get our share of experts emerging from our own economic rubble. On hearing them a very, very few people will have the privilege of knowing that they were wise before the event, which is so much harder than being wise after it. If they're particularly shrewd they'll keep their mouths shut, because by then the world will be a very different place.

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