For investors who had money in the markets last year, October 2008 is a month that will not soon be forgotten. In those 31 days, the S&P 500 – a major indicator of the stock market at large – fell almost 17%, reversing the gains of the previous five years.

But as the markets work their way back into health and investor confidence continues to creep up month after month, we risk throwing away the lessons of the Subprime Crash of 2008:

Lots of very intelligent investors got embroiled in huge losses last year. Bernie Madoff fleeced scores of wealthy, well-informed investors – many of whom lost everything they had built up over a lifetime. The collapse of some of the biggest financial institutions, including Lehman Brothers and Bear Stearns, thinned out the Wall Street crowd by the millions. And underperforming fund managers hit close to home by taking a bite out of out 401Ks.

In fact, over the course of the last year, the average mutual fund lost 20.95% of its value according to Morningstar. That’s a shock for investors who were used to raking in double-digit gains year after year.

If nothing else, there should be some pretty big takeaways from this financial fiasco. Here are three that you should be walking away with:

1. Know What You Own

Knowing what you own is one of the tenets of stock investing. But it means more than being able to name the holdings you have in your portfolio. In late 2007 and early 2008, the general consensus on stocks was that the bullish tone of the market was set to continue.

But in reality, stocks had been expensive for quite some time. Just how valuable were stocks before the bottom fell out of the market? Here’s a look at historical P/Es of the S&P 500 every quarter since 1936:

The consensus is generally that the average P/E of the S&P 500 is around 10; it’s not. Since 1936, the S&P 500 has averaged 15.8.

But in late 2008 the S&P’s price to earnings ratio had risen to the mid 20s. In fact, they hadn’t touched that 15.8 average in 13 years. For the first two quarters of 2008 before stocks went into freefall, the S&P’s P/E ratio averaged just over 23… 45.5% higher than the historic average.

Now, there are a lot of reasons why the market should have a higher P/E than it has in the past – constituent companies have changed pretty dramatically in the last 73 years, for starters – but that still doesn’t explain why companies delivered investors with 39% less earnings bang for their buck between 2005 and 2008.

The information suggesting that the market might be overvalued was easily available, but the investor sentiment told us to buy full steam ahead.

2. “The Market Can Stay Irrational Longer than You Can Stay Solvent”

That famous quote from economist John Maynard Keynes resounds just as true today as it did in the 1930s. Keynes was qualified to make a statement like that – he was one of a few prescient investors who made a fortune by avoiding the great depression, and picking up undervalued stocks dirt cheap in its aftermath.

Markets tend to overreact to important news. They overreacted to the subprime crisis by slashing stock prices by an average of almost 50%, and they’ll likely overreact again as we recover from March 9’s market lows.

Those overreactions are only magnified when it comes to penny stocks. Because the smallest companies have the smallest trading volumes, their true values and share prices are often not reconciled. And while that can provide penny stock investors with a huge buying opportunity, it can also provide us with a huge headache as we wait for our valuations to come to bear.

3. Don’t Believe the Hype

The mainstream financial media deserves a share of the blame too… Traditionally, the tone at the major financial networks has been pretty predictable – their pundits sing the market’s praises when things are good, and solemnly decry the dangers of stock investing when things turn sour.

And as the first signs of the subprime collapse started rearing their ugly head, the pundits were in full perma-bull mode…

It’s time to take what we hear on the financial news with a grain of salt.

Cheers,
Jonas Elmerraji

Source: Three Lessons Learned from the Subprime Crash