We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. —Warren Buffett

The financial markets turmoil of the last year has taught, or retaught, all of us a lot about risk and risk management. In the halcyon days before 2008, risk management was an occasional activity that we believed we knew something about. Today we are serious about it. Further, in the short space of about a year, we may have learned a little—now we know that the normal distribution is often abnormal, that “impossible” events happen and that all those uncorrelated asset classes can sink together—at exactly the moment you most need the correlation benefit.

Our respect for market turmoil is much greater and our understanding of markets, maybe, has increased.

However, for investors, the market and its gyrations are only half the problem—we’re the other half. Or, in the words of Pogo,1 “We have met the enemy and he is us.”

As shocking and dismaying as the housing boom-bust and financial crisis are, they are not unprecedented. Housing is following the same boom-bust pattern that markets have experienced for centuries. The oldest commonly cited cycle is the Dutch tulip bulbs in 1637, as chronicled by Charles MacKay.2 A more recent analysis is provided by Charles Kindleberger in “Mania, Panics, and Crashes.”3 Kindleberger recounts a number of infamous booms and busts and describes their typical pattern as shown in Figure 1. The boom begins with some event—“displacement” in Kindleberger’s terms—that disrupts an otherwise normal market. With housing in the U.S., this was the very-low-interest-rate environment in 2002–2003, just as investors, shell-shocked by a bear market, were seeking an alternative to investing in stocks. Their homes—and second homes—offered the best alternative. As the boom gathered steam, soaring prices led people to believe home prices would never fall, and generated positive feedback to drive the boom. This psychology was soon joined by subprime mortgages, which dramatically expanded the market. Ever-expanding securitization of those mortgages sparked the speculative mania seen at the peak in 2006. By 2008 the boom had turned into a bust, or the “crisis and revulsion” noted by Kindleberger. This pattern, with minor changes, can be seen in other booms. Figure 2 tells the story for the technology stock market of 1995–2000, alongside the housing cycle. One can easily find many other stories that fit the same pattern.

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