It is eight years since the collapse of Lehman Brothers triggered a global financial crisis. There are three areas where the financial crisis brought change: the investment environment, the psychology of investors, and in attitudes to systemic risks.
In terms of the investment environment, the crisis intensified a regime shift that was already in place and has significantly shaken up players in the investment industry. Prior to the crisis there had been a decline in inflation and interest rates, but the effects of 2008 have pushed this to extremes. In addition, central bankers have responded to periodic growth weakness with monetary policy easing. The result is that bonds and bond-like assets have delivered what are traditionally considered to be equity-style returns.
The main impact of the financial collapse on investor psychology was not a lesson but a reminder. For investors, clients, and regulators it brought home the concept of ‘tail risk’. This is nothing new, but the weight that we attach to such unexpected events waxes and wanes with recent experience. We move between phases of calm to periods in which ‘the next crash’ is around every corner.
Across the industry, investor time horizons have shortened and willingness to tolerate volatility has declined. Many investors seem far more focused on managing short term volatility and especially draw-down. For many, this is how risk is defined, sometimes even at the expense of the ultimate long term goal.
The industry has responded with a growth in the range of funds with implicit or explicit draw-down or volatility guarantees. To date, these funds have benefited from an environment in which government bonds and large-cap equities have performed strongly.
The financial crisis and its aftermath brought home the systemic risks associated with leverage. Leverage [borrowing] has the impact of amplifying and spreading the impact of what would otherwise be contained events. Since the financial crisis, banks have cleaned up their balance sheets. Leverage in itself is not a bad thing, but it is vital that any downside is borne by those taking the risk and not society at large.