Early August marked the first anniversary of the credit crunch. The infant that arrived unheralded and unwelcome on the doorstep of the financial world is now, believe it or not, just over one year old. While we all hoped that its unhappy life would be a short one, it now seems as though this unwanted foundling is going to be with us for a while yet. And, by all accounts, it is going to cause us a lot more sleepless nights before it goes away.

If the credit crunch were a storm we might now be in its eye – that expanse of uneasy calm in the storm’s centre, which whispers to the unwary that the worst is behind them. No chance, I’m afraid, if we listen to the utterances of those in high places. For example, former IMF chief economist Ken Rogoff warned recently that the credit crisis in America is only half over: “America is not out of the woods … The worst is yet to come,” he said. Rogoff also predicted that bankruptcies would not be confined to mid-sized banks – “we’re going to see a big one collapse in the next few months,” he warned.

It is not difficult, in the midst of this media barrage, to accept that this financial crisis is going to be worse than anything most of us have experienced in our lifetime. As desperate times call for desperate measures, what action should equity investors take in the face of this “perfect storm”? I read far and wide in search of an answer, and spoke to those in the financial services industry whose opinions I respect. The answers I got were not those I expected when I set out on my quest.

If you will indulge me, I would like to enlighten you in part by way of a parable. It tells the tale of Chicken Little, and the abbreviated version goes like this:

Chicken Little was walking through the woods one day when an acorn fell on her head. It scared her so much she trembled all over. She shook so hard, half her feathers fell out.

“Help, help! The sky is falling! I have to go tell the king!”

So she ran in great fright to tell the king. As she rushed along, one by one she came across a number of her friends - Henny Penny, Ducky Lucky, Goosey Loosey and Turkey Lurkey. To each one of them, in turn, she cried out:

“Oh help! The sky is falling!”

And each one in turn asked: “How do you know?”

“I saw it with my own eyes, and heard it with my own ears, and part of it fell on my head! I am going to tell the king!” said Chicken Little.

Each of her friends agreed that this was terrible news and joined Chicken Little on her mission, all of them running as fast as they could down the road.

Before long the rushing group met Foxy Loxy, who greeted them with a friendly smile and said: “Well, well. Where are you rushing on such a fine day?”

Chicken Little explained that it was not a fine day at all. The sky was falling, and they were running to tell the king.

“I see,” said Foxy Loxy. “Well then, follow me and I’ll show you the way to the king.” *

So they all followed Foxy Loxy, across a field and through the woods, straight to Foxy Loxy’s den. And none of them ever saw the king to tell him that the sky was falling.

To understand this parable in its financial context, we need some more information. Ponder this, if you will:

(1) In the 12 months following the terrorist attacks of 11 September 2001, many Americans chose to drive rather than take domestic flights. As a result the number of people killed in road accidents over that year rose by about 1600. This was six times the number who died in the hijacked aircraft.

(2) George Loewenstein, an academic at Carnegie Mellon University in Pittsburgh, Pennsylvania, who teaches decision-making, recalls how after 9/11 an economist colleague of his whom he had always considered “a paragon of rationality,” chose to drive rather than fly to distant meetings.

“Rather than deliberating about a long-term strategy to counter a risk, people often seem to go into panic mode and take actions that actually exacerbate the problem they are worried about,” Loewenstein says.

(3) Crime rates in the US fell by 20% between 1990 and 1998. However, the majority of residents believed that crime had increased during this time. During this particular period, TV coverage of crime in the U.S. rose by 83% while, more significantly, coverage of homicides rose by 473%. The actual number of homicides fell by 33%.

If you are totally confused by now, please bear with me. There are a few factors at work here that will help to make things clearer: (Numbers (i) to (iii) below refer to points 1 to 3 above).

(i) We are bad at making good decisions in risky situations. The key to this lies in our emotional response – when we are distressed or otherwise emotionally aroused, we seem to be incapable of soberly weighing up our options. Instead, we are led by our feelings.

(ii) In emotionally charged circumstances, few people want to check the evidence. For instance, Michael Sivak and Michael Flannagan of the University of Michigan have determined that driving the length of a typical domestic flight in the U.S. (estimated at 1,157 kilometres) is 65 times riskier than flying.

(iii) The disproportionate reporting of dramatic events distorts decision-making when it leads to an “availability cascade.” This is a process which makes a story more believable as more and more people accept it as fact, and retell it as such. Cass Sunstein at the University of Chicago Law School and Timur Kuran at Duke University in Durham, North Carolina, explain that availability cascades stem from the fact that people have limited knowledge about most things. As a result, each of us depends for information on what other people seem to know.

This is a particular danger when “other people” includes the various forms of the media, who all beam out the same story, often in a sensationalized and distorted manner.

We can now use this information to help us interpret the lessons that the Chicken Little story can teach us. To begin with, we can liken Chicken Little to the media – when a relatively minor event occurs, she over-reacts and believes that the sky is falling. Each of her friends who hear the news reacts with an emotional knee-jerk reaction, and does not stop to rationally examine Chicken Little’s claim. As the news spreads and the group grows, (the “availability cascade”) each subsequent bird met along the way is swept along on the emotional tide. Finally, only Foxy Loxy makes a rational analysis of the situation, and the birds come to an unfortunate end.

I have to admit that the credit crunch media storm had me reacting the same way. In these once-in-a-century circumstances, how should we react? Should investors move out of equities and into bonds? And should these be corporate or government bonds, or both? I asked one of my trusted financial services friends, a man who manages a number of large equity portfolios for various high net-worth individuals, what he was going to do in the face of this disastrous event.

His answer was simple: “Nothing”.

In reaction to my slack-jawed expression of amazement, he explained that he followed a value-investment strategy. When I suggested that markets might crash and that bonds might provide a safe haven until the storm was over, he merely smiled indulgently. A crash, he explained, would provide opportunity for further equity purchases – the last thing he wanted was to be out of the market, unless I could tell him exactly when the crash and subsequent upswing would take place. (The classic error of trying to time the market). He was going to stick to his value-investing principles, re-balancing his clients’ portfolios according to a previously agreed timetable, and actually increasing their investments as the market declined and earnings and dividend yields improved.

He is right, of course, and his advice serves to emphasise how careful we must be to avoid an emotion-driven, knee-jerk reaction in the face of seemingly cataclysmic events. As George Loewenstein put it earlier:

“Rather than deliberating about a long-term strategy to counter a risk, people often seem to go into panic mode and take actions that actually exacerbate the problem they are worried about.”

Warren Buffett agrees. In his introduction to the fourth edition of Benjamin Graham’s value-investing classic, The Intelligent Investor, Buffett says:

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”

Buffett goes on to say: “Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well as on the amplitudes of stock-market folly that prevail during your investment career.”

This final point is re-emphasised in the tribute to Graham which Buffett wrote in The Financial Analysts Journal in 1976, shortly after Graham’s death:

“In an area where much looks foolish within weeks or months after publication, Ben’s principles have remained sound – their value often enhanced and better understood in the wake of financial storms that demolished flimsier structures.”

This is not to diminish the possible severity of the credit crunch, or the recession which very well might follow. But at the end of the day, most good companies will survive. Their share prices may fall during the recession, but if history teaches us any lessons it is that those share prices will rise again above their previous highs.

It is a time for cool minds and a proven strategy - not the time to panic, or to be a little chicken!

Source: A.J. Cilliers, Sharenet, October 2008.

*AJ Cilliers is a Senior Lecturer in the Department of Accounting at the University of Cape Town, specializing in Managerial Accounting and Financial Management. AJ held senior accounting and financial management positions in a number of well-known South African companies, before joining UCT some five years ago. His current areas of interest include the valuation and management of investments, value-based management, and the emerging field of behavioural finance. AJ is also a life-long student of personal development, and is bound to share this passion with you in the months to come!

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