Read Young Money Magazine

As a member of YoungMoney.com you can read the digital magazine online.

Lessons from the Financial Crisis

By Bill Pratt (past articles)
http://www.thegraduatesguide.com
12/02/2008

Email This Article

Subscribe Now!

There are several lessons that we can take away from the current financial crisis. These lessons include personal and business lessons as well. We are all learning more about the economy and various industries than what we probably ever wanted to know. Perhaps as we weather this storm and actively try to resolve it, we can take away some of these lessons and come out the other side a bit stronger, economically and financially.

Lesson #1 - Leveraging your debt is risky

Most of us know this basic lesson. If you invest $10,000 into a $100,000 house and the house goes up in value by just 10%, then your initial investment goes up by 100%. Leveraging is the only way that works. But we can't forget the other lesson. There is a balance between risk and reward. What happens when the house value drops 10%? You LOSE 100% of your investment. What happens if it drops 20%? You lose all of your initial investment, plus you lost an additional 100% of your initial investment. Unlike purchasing a share of stock, where you can only lose what you put in, leveraging your money can result in losses much greater than you initially wanted to invest. In theory, you could invest $10,000 in a $100,000 house and end up losing a total of $100,000! All from a $10,000 investment. Ouch. I am not saying you should never leverage, but let's keep in mind what the downside risk is as well as the upset potential. "What doesn't kill you makes you stronger… or leaves you permanently injured."

Lesson #2 - Reacting, rather than responding, can lead to chaos

Just look at what Congress did. It was an election year on top of everything else, so they reacted to the crisis rather than responding to it. Now we are squabbling over which industries can get the money. The Treasury Secretary has changed his mind about what to use the money for. The banks are not lending it the way they were supposed to. Congress has a difficult time fixing anything over the course of a few years. Why would anyone have believed that Congress could fix anything in two weeks? While I appreciate the desire to act quickly, I don't appreciate acting recklessly… with $700 billion nonetheless.

Gas prices? The speculators started it all, but we all got caught up in the hysteria of rising gas prices. The world demand for oil did not triple. The production did not get cut by 75%. Then why did the prices spike? The financial markets, consumers, government officials, auto industry insiders, oil companies, and so on got caught up in the same type of bubble that we just saw with the housing markets, and previously with the tech stocks. Between the weakening dollar and the mass hysteria, gas skyrocketed and has now come down almost to the 2004 prices. Again, instead of responding, the proverbial "we" overreacted and look where it got us? Probably permanent price increases in food and airline prices, even though gas is finally coming back down. Of course the industry also learned that a 100% jump in gasoline prices only resulted in a small decrease in use.

Page Two: Tomorrow may be different and live within your means

1 2 Next Page