Gather Little by Little

On September, 15^th 2008, the financial world almost collapsed upon one of the biggest failures in Wall Street history: The bankruptcy of Lehman Brothers. Upon this major news, the stocks markets started one of the most important and surely the fastest drop of its long history. A year later, nothing much has been done about banking laws and protecting consumers from the rise of another economic bubble. While the US government hasn’t shown us what they have learned much so far (the debate was rapidly redirected towards the healthcare system), it doesn’t mean you can’t apply a few lessons from the Lehman Brothers’ failure to your own personal finances!

Lehman Brothers’ lessons on managing credit

#1 Do not leverage when you can’t afford it

I am actually a big fan of leveraging. It has been proven many times over that making money with other people’s money (in a respectful and legal way) is the fastest method to increase your net worth. When you think about it, just about everybody leverages: you leverage when you buy a house (mortgage) and you leverage on the fact that you will get a pay check in 2 weeks or at the end of the  month when you lease/buy a car or financially engage in any other type of contract. However, while leverage may be useful, borrowing more than you can pay back is very dangerous. Lehman Brothers’ definitely used leverage beyond its financial capacity and paid the highest price; bankruptcy. This is why you should not use leverage at large”¦ and if you leverage, make sure you know what you are doing.

#2 Do not depend on others to pay your debts

Another important fact that pushed Lehman over the cliff was the loss of confidence by most investors. Once the rumors started, several investors took all their investments out creating a humongous gap between Lehman Brothers’ financial obligations (i.e. debts) and their assets (i.e. investments). If you count on the money someone owes you or on the promise to of a pay check to settle your debts, you may be late or face the sad truth of not receiving the money at all and not being able to pay your debts. Make sure to borrow only as much as you can afford to pay back!

Lehman Brothers’ lesson on managing your investments

#1 Do not invest in something you don’t understand

This piece of wisdom actually comes from Warren Buffett himself. He never invested money in credit default swaps or other derivative investment products he didn’t understand. Wall Street came up with these highly complex investment products that no one (not even the manufacturers) were able to understand. They were selling something with a good expected rate of return without even reading an investment guide. So when you are looking at your stock portfolio, maybe you should consider simple investment products without being fooled by unreal yield promises. I can never say it enough: There is no free lunch in finance!

#2 When you start losing money, do not swing for a homerun to get your money back

The panic had reached a summit on Wall Street upon the big announcement and many traders tried “get their money back” by taking on more risk. They pretty much looked like gamblers in a Casino at 2AM: they keep betting their wild card in the hope of finding the Ace at the last minute. Result: they lost even more money. If you have investments, you will see devaluation from time to time. It is normal to see your stock portfolio drop once in a while. But chances are you won’t recover from your losses through riskier trades. By keeping your original investment strategy, you should get your money back at some point. Time is your best ally!

Lehman Brothers’ lesson for personal finance in general:

#1Wishful thinking doesn’t work

Traders at Lehman Brothers’ knew it was only a matter of time before they would see their exotic investment products blow up in their faces. They were holding a time bomb in their hands and were simply wishing:

“The markets will go back up and it will all settle down”.

“We just have to hold out for a few more weeks and we will be all right”.

Unfortunately, wishful thinking doesn’t work in finance. This is a personal growth concept; not an asset building strategy. If you are spending more than you are earning, you can’t keep doing it by thinking “I’ll be fine, I’ll find more money before it’s required”. The truth is that if you don’t have a plan to get out of debt, you probably won’t!

In the end, I guess that Lehman Brothers’ and the other big guns from Wall Street always thought they were untouchable. The fact they were holding billions in their hands created a false bubble of protection. They even pushed their arrogance to think the US Government would save all of them as a bankruptcy would not be a viable option for Wall Street. So here’s the last lesson and THE most important one to learn from the Lehman Brothers’ failure:

Never assume.

Author: Mike.

Image source: Christopher S. Penn.