I recently attended the Bank of Butterfield's ("Bank") Annual General Meeting ("AGM"). The atmosphere was a bit hostile but the shareholders' comments were quite reserved. A public relations expert who attended the AGM described the shareholders as far less hostile than similar bank AGMs and said the majority of their questions and comments were well researched and intellectual. I have come away with a couple of lessons that many investors can glean from an unfortunate event such as this. Much of the hardships suffered by shareholders and management could have been avoided by following some simple financial axioms:

1 Diversification

As a financial adviser it was a bit shocking to me to note the number of families or individuals that seem to have tied up a significant amount of their net worth in the Bank's common shares.

Diversification is the only free lunch in investing. It is important to diversify your investments across the capital structure (bonds vs. stocks), across industries, and geographies. It is not advisable to have single stock concentrations in excess of five percent of your net worth. A worrying factor that has surfaced is the lack of diversification in many individual Bermudian, endowment, trust and company investment portfolios.

It appears that the booming local economy over the past 20 years and the subsequent rise in Bermuda share prices and dividends convinced many investors that there was little risk in concentrating their investments in the limited number of local stocks.

The sharp fall in the Bank's share price and its dividend suspension has caused a great deal of pain for local investors who failed to diversify their investments geographically.

Part of the market meltdown in Japan during the early 90s was the result of the unwinding of the "keiretsu" system. The keiretsu system essentially involved Japanese companies owning pieces of each other. Once the economy and the stock market began to collapse the losses accelerated for all connected companies due to their concentrated cross-ownerships. They were essentially non-diversified conglomerates of Japanese companies.

Witness the effect that the hardships at the Bank have had on Argus shareholders who have also suffered a dividend cut as a result of the Bank's woes. Do yourself a favour and ensure your portfolio is not excessively tied to one company, industry or country.

2 Loss Aversion

There is a saying in the investment industry that "your first loss is your best loss". It basically means it is best to cut your losers early and admit defeat. As investors we are not wired to follow this rule. In fact we all suffer from a behavioural bias called loss aversion — the tendency to hold on to losers far too long.

This feeling is typically supported by an internal narrative about a likely turnaround or rebound, but in most cases it is simply a subconscious message used by an investor to avoid feeling bad about realising a loss. In essence when we sell a loser it remains a loser forever which erodes our confidence.

At the Bank's AGM in 2009 some investors perpetuated this by claiming the Bank was now a "deal at these levels". A sense of "the worst is over" was suggested instead of acknowledging the hardships the Bank was dealing with and the impact of the global economic downturn.

Butterfield's management also appears to have succumbed to the same loss aversion attribute by not dealing with write-offs of poor investments and failing to raise equity capital earlier.

Had they raised capital in the form of a rights issuance and/or equity offering at the same time as the preferred issue, shareholders would not have suffered as much dilution.

To be fair, an equity raise was absolutely unavoidable. However, if it had been done a year earlier it would have been far less costly to existing shareholders.

The same amount of capital may have been raised in a $3 rights offering when the share price was much higher. Approximately 180,000 new common shares may have been issued instead of over 450,000 this year.

Clearly banks that recognised capital deficiencies caused by investment and loan losses early in the credit crisis benefited from raising sufficient capital rather than hoping things would get better.

Nathan Kowalski is the chief financial officer at Anchor Investment Management. He holds a Chartered Financial Analyst (CFA) designation and Chartered Accountant (CA) designation. Anchor Investment Management Ltd. is licensed to conduct investment business by the Bermuda Monetary Authority. To contact Anchor, e-mail info@anchor.bm or phone 296-3515.