3 Pearls of Financial Wisdom From Alan Greenspan

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Known as the Oracle, Alan Greenspan is one of the most widely respected Federal Chairmen of all time due to both his economic knowledge and political savvy.

A familiar face throughout two decades of U.S. history, Greenspan is the second-longest serving Federal Reserve Chairman (1987–2006), just four months behind the top spot. Throughout his long tenure in public service and his prolific career in economic consulting, he accumulated a thorough understanding of how markets work.

Here are the three best pearls of financial wisdom from Alan Greenspan.

1. Beware "Home Bias" in Investments

In his memoir The Age of Turbulence, Greenspan warns investors about their tendency to invest their savings in their home country, even though this could mean passing up more profitable foreign opportunities.

The problem with having a narrow geographical scope for your investment portfolio is that you may undervalue its actual risk. "When people are familiar with an investment environment, they perceive less risk than they do for objectively comparable investments in distant, less familiar environs," he points out in his book.

Diversification is key in order to spread out and minimize your investment risk. Just like you wouldn't put your entire nest egg in a single stock, you shouldn't limit your investments only to the U.S. economy. By including exposure to both domestic and foreign markets, you may be able to ride out bumps in the U.S. economy with price gains in foreign markets, and vice versa.

To keep transaction costs predictable and reduce special risks in international investing, such as currency exchange rates, political events, and different market operations, the SEC suggests you consider the following foreign investment options:

• Mutual funds, such as global funds, international index funds, and regional/country funds;
   
• Exchange-traded funds, which unlike an international index mutual fund, trade on a stock exchange;
   
• American depositary receipts, which are certificates issued by U.S depositary banks providing ownership interest in foreign corporations;
   
• U.S. traded foreign stocks, such as Canadian (e.g. NYSE:BMO) or Chinese stocks (e.g. NASDAQ:BIDU).

Consult with your financial planner or retirement plan administrator to find out more details about your options in foreign investments and to determine whether or not those options make sense for your portfolio.

2. Keep "Irrational Exuberance" in Check

You can't talk about Alan Greenspan without touching on the topic of "irrational exuberance."

He coined this term during his keynote address "The Challenge of Central Banking in a Democratic Society" at the American Enterprise Institute's annual dinner in December 1996. Greenspan prepared a pretty dense speech and he wasn't sure what part of it would make the news. The day after his speech the media focused on this bit, "How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?"

For the average investor, the main takeaway is that we have to leave emotions out of investing. When you can't support your investment decisions through cold hard numbers or market fundamentals, then you become a victim of an investment bubble of your own creation. Unsustainable investor enthusiasm often takes place during periods of economic boom. For example, Forbes has called 2015 the "age of unicorns" because there are more than 80 startups with $1 billion or higher market valuation.

When it comes to investing you have to do your due diligence, you can't just wing it or play it by ear.

Greenspan believes that the best way to keep irrational exuberance in check is to study the history of financial markets and learn from the experience of past generations. Improving your financial literacy is a common suggestion from past chairs of the Federal Reserve because "Bearnanke" also stands behind that recommendation. (See also: The 5 Best Pieces of Financial Wisdom From Ben Bernanke)

3. Hold Stocks Beyond Your "Sleeping Point"

Given that Warren Buffett is not only one of history's most successful investors but also one of his dearest friends, Greenspan pays close attention to the investing lessons from the Oracle of Omaha.

In The Age of Turbulence, Greenspan points out that Buffett's favorite holding period is forever. The main reason is that several studies have pointed out the historical average market return of 8.5%. Many investors miss out on that potential return because they sell their positions in times of recession for purely emotional reasons.

"The market pays a premium to those willing to endure the angst of watching their net worth fluctuate beyond what Wall Streeters call the 'sleeping point,'" writes Greenspan. There are many valid reasons to sell your stocks, such as rebalancing your portfolio back to its target asset allocations or materializing losses to offset big income gains for tax purposes.

However, selling down to the sleeping point — taking only the risk that still allows you to sleep at night — shouldn't be relied on to emotionally nix your stocks. Take a cue from both Greenspan and Buffet and remember that the well-documented higher rate of return of equities, even adjusted for risk, exceeds that of alternative investments, provided you're willing to buy and hold stocks for the very long run.

Investing can feel sometimes as the most unpredictable thing in the world. "Markets do very weird things because it reacts to how people behave, and sometimes people are a little screwy," warns Greenspan.

By having an understanding of the concepts of home bias, irrational exuberance, and sleeping point, you're better equipped to keep a methodical investment strategy.

What are other great pearls of financial wisdom from Alan Greenspan?