The financial markets have grown, shrunk, recovered, and been on a roller coaster ride over the years. Although each recession is different, there are some similarities and recurring indicators that can offer insights for investors, families and individuals.
Past financial crises can be a useful guide for people to make better decisions in the face of uncertainty. In contrast to worrying about market fluctuations or getting carried away by the noise in the media. Learning about past events can enable them to understand the risks, plan accordingly, and think about building long-term wealth when they start to see the signs of a potential market downturn.
Economic Cycles are a Normal Part of Markets
The most important thing to be learned from the past in finance is that cycles come and cycles go. Expansions are typically followed by corrections, slowdowns or recessions. These occur at different times and intensities, but have happened over and over again in markets, and growth never lasts forever without a break.
Economic downturns may be caused by any of several factors:
- Excessive debt accumulation
- Asset price bubbles
- Inflationary pressures
- Rising interest rates
- Weak consumer confidence
- Global economic disruptions
History Shows the Cost of Emotional Decision-Making
Throughout history, an alarming pattern has emerged: fear often causes investors to make poor financial decisions. When times are uncertain, some people make hasty decisions to sell investments or to give up on long-term investment plans, or make radical portfolio changes in response to short-term market fluctuations.
History has shown that when a person reacts emotionally, they often will:
- Selling at the market lows
- Missing recovery opportunities
- Increased financial stress
- Poor long-term returns
Signs of an Unfolding Financial Crash
Concerns about an unfolding financial crash often arise when multiple economic warning signs begin appearing simultaneously. No one knows what will happen in the market, but history says that when times are risky, there is a mix of economic imbalances and uncertainty.
Some signs that you should be alert for are:
- Excessive borrowing
- Declining consumer spending
- Corporate earnings weakness
- Tightening credit conditions
- Persistent inflation concerns
Diversification a Powerful Risk Management Tool
The practice of diversification has always been a key feature of financial crises. Focusing investment in a single asset class, industry, or market sector can subject an investor to greater risk during a downturn. Diversification can be used to lower the risk by allocating investment to multiple geographical regions, e.g. by investing in:
- Stocks
- Bonds
- Cash reserves
- Real assets
- International investments
Diversification cannot guarantee that losses will not occur, but it can minimize the effect of market volatility on an overall portfolio.
Conclusion
History does not always tell us exactly what will happen in the future, but it does provide some lessons on how financial crises come about and how one can account for uncertainty. Recognizing the early warning signs of an economic downturn, taking an informed approach to risk, and having a long-term perspective, individuals can make better investment decisions when they face tough economic times.
