Managing The Risks In Ourselves - TALKING INDEXES

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.

The markets, however, are only half the game. The rest is how we reacted to market events and why we bought into the idea that home prices would never fall. A common question one hears from investors is why financial advisers and analysts didn’t realize what was happening and predict the downturn. A less common question one hears a few people asking themselves is why they didn’t realize what was going on and anticipate the collapse. Very few people think back to how they felt in 2006 as the housing boom was peaking, or what they were feeling in 2002 as it was getting under way.

Let’s begin with 2002. The bear market that started in March 2000 was bottoming out in the last quarter of 2002, the economy was creeping out of a shallow recession and many were still nervous about global politics after the events of Sept. 11, 2001. Investors were worried, and no one expected the housing boom. Indeed, not many even expected the market to recover from a 50 percent loss in only five years. Between fear and greed, fear ruled the day. Yet both the stock and housing markets were at a bottom, and were about to surge upward.

Now, consider the summer of 2006, when housing was peaking. Investors’ attitudes were completely different. The economy was growing, stocks were gaining and the S&P 500 had risen from under 800 to over 1200 since the fall of 2002. The big news was in housing, where home prices were up sharply, with some sunbelt cities seeing prices over twice the levels of early 2000. The last thing on most investors’ minds was a collapse. Between fear and greed, greed ruled the day.

Figure 3 shows the Kindleberger boom-bust cycle seen in Figure 1 and adds a second line illustrating the level of risk that investors perceived. In 2002, when fear ruled the day, people saw very large risks; in 2006, when greed dominated, perceived risks were small. The track of apparent risk is just the opposite of the market—at market bottoms we see huge risks, while at market tops we are incredibly bullish.

A large part of risk management is knowing if a particular risk is justified by the opportunity of reward. In the markets, as in most things, the size and probability of the reward varies with time and conditions. Yet the way most of us think about the markets gets the timing and probability of success backwards. There is more to investing than reason and numbers when everyone else is paralyzed with fear. The trick is to recognize when the madness of the crowd is prodding you to believe in the popular delusions.

2) Charles MacKay, “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds,” 1841