The global financial crisis of 2008-09 reminded asset owners and investment managers that they should worry not only about risk and return, but also about liquidity.
The best laid plans for protecting investment gains, and even the corpus of a portfolio, could fail if attention is not paid to the likely shortage of liquidity.
In the event of a financial crisis, liquidity disappears as quickly as the morning dew when the sun appears. That is what happened in September 2008 when the federal government declined to bail out Lehman Brothers Holdings Inc. Sources of liquidity dried up around the world. Investors could not sell the stocks or bonds they wished to sell in a timely fashion and at acceptable prices.
Unfortunately, because liquidity tends to flee when danger appears, it must be locked up before a crisis is obvious, and that affects returns.
The decision asset owners and managers must make constantly is how much liquidity protection to buy, and they also must make certain their source of liquidity will remain available in a deep crisis such as that of 2008. Liquidity cannot be arranged on the fly when a crisis is coming to a head and all can see it coming.
The greater focus on liquidity is a critical part of risk management, which many managers and assets owners have taken steps to enhance as one of the lessons learned from the global financial crisis.
The question is, will these lessons be remembered as the pain of the crisis continues to fade?
Asset owners and managers claimed to have learned the lessons of enhanced risk management after the dot-com bubble burst in 2000. Some pension funds and investment management institutions appointed chief risk officers to improve risk controls, but there is little evidence that enhanced risk management practices helped in 2008.
Investors also must be more aware. Few recognize when conditions that could lead to a crisis are brewing, and those who do often misjudge the timing and fail to act to protect themselves and their clients from the full impact of the storm.
Few investors recognized the housing bubble and the declining quality of the mortgages backing securities that were flooding the market. Many took at face value the claims that the mortgage-backed securities were backed by diversified portfolios of mortgages. The depth of research on which managers made investment decisions was not sufficient.
This suggests that analysts, managers and asset owners must improve the quality of their analysis of developments in market sectors, and the impact of economic and political developments on those sectors. In particular, they must pay more attention to the impact of worst-case outcomes on the markets and portfolios.
Unfortunately, often asset owners and money managers are not dealing with "risk" — which is defined as a situation in which you can assign a probability to a possible outcome — but "uncertainty," defined as a situation in which not enough is known to assign a probability. Uncertainty is much more difficult to deal with.
This might be the situation developing now, with the Federal Reserve beginning to increase interest rates as President Donald Trump is pushing up tariffs against China, the European Union and other countries at a time when the stock market looks expensive.
The ultimate outcome of these conflicting tides is unpredictable. Asset owners and their investment managers should be focusing on their risk management programs and their liquidity barricades to prepare for a potential bad outcome. These programs might not be perfect, but they would reduce the pain of any correction.