In theory, portfolio insurance had all the benefits of stock ownership without the risk. If stocks began to decline, the investor would magically be shifted out of stocks. This seemed like such a great idea that firms sold this insurance and many investors bought it.
What happened to those who bought portfolio insurance? They got massacred in the 1987 stock market crash.15 And they almost destroyed everyone else, too. In the second half of 1987, the stock market began to decline. As stocks declined, those who owned portfolio insurance sold stocks, which in turn caused prices to fall further. This selling culminated in the Dow Jones Industrial Average losing over 20% of its value in one day. The decline in the 1987 crash in percentage terms was almost twice as large as the 1929 crash.16
Investors’ portfolios turned out not to be protected from the 1987 crash. The theoretical analysis of portfolio insurance, assumed that markets would move gradually. In the real world, prices did not move gradually, but rather took huge steps down. Investors who thought they would exit stocks after small declines found themselves selling at precisely the wrong time.
If only one person had used portfolio insurance, it might have worked fine. Because the strategy was common, however, the system built upon itself to create a selling frenzy. Those with portfolio insurance made the worst mistake possible in mean markets; they bought at the top and put themselves in a position where they had to sell at the bottom.
Similarly, if Brent were the only person with a “sell if rates rise” strategy, it might work fine. However, the truth is exactly the opposite. One-third of new mortgages are adjustable-rate mortgages, which is near an all-time high.17 The prevalence of adjustable-rate mortgages makes the “sell my place if interest rates rise” strategy risky. If interest rates continue to rise, then millions of homeowners will be looking to sell when their mortgages adjust. This is unlikely to be a profitable time to be a seller.
When bad things happen they often appear unavoidable. In reality, however, the required steps to avoid ruin need to be taken much earlier. This is something that investors need to know, and also something that would have helped a man named Robert Brecheen.
At around 9 P.M. on August 10, 1995, Robert Brecheen tried to commit suicide by overdosing on pain pills. Mr. Brecheen was rushed to the hospital and revived by the administration of powerful drugs. At 1:55 on August 11, just five hours later, Mr. Brecheen was executed by lethal injection in the Oklahoma State Penitentiary.18
Mr. Brecheen was sentenced to death for committing murder in the first degree. After years on death row, all of his appeals had been denied and his execution loomed. Rather than let the state kill him, Mr. Brecheen decided that he would control the time and manner of his own death by committing suicide. Even in this, he failed. Mr. Brecheen got into a situation where he had zero control over his life. He was not able to even decide how or when to die.
Investors who are on the wrong side of mean markets face outcomes that are far less severe than execution but similarly inflexible. Those who buy at that top are often forced to sell at the bottom. A key to making money in mean markets is to retain control of the time of one’s buying and selling.
Adjustable-rate mortgages remove control of when to sell a home. Those with adjustable-rate mortgages may be pressured to sell their properties at the same time as others. Thus, those who seek to profit from market craziness should avoid adjustable-rate mortgages.
Solution #1: Plan to Buy a Larger Home in the Future
The Mean Markets and Lizard Brains advice is to own some real estate but expect to move to a more expensive property in the future. If housing prices were a bubble, the correct strategy would be to own nothing and rent. Because housing prices are high, but not in a bubble, the suggestion is to own something less than your dream house. This strategy can be profitable regardless of whether housing prices fall or rise. How can this strategy win in all environments? Here’s how a similar strategy worked in the stock market.
Near the top of the technology stock bubble, I found out that my older sister Sue had invested most of her retirement account in an aggressive technology mutual fund. I suggested that this was a very bad idea and that she sell. Some weeks after she agreed to sell her overvalued tech stocks, I asked if sister Sue had made the phone call to change her investment. “No,” she said, “ I haven’t, I don’t want to miss the rally.”
To solve the problem we came up with the following strategy. Sister Sue sold one-quarter of her stocks. Now, I said, if stocks go up you will make a ton of money as you still have hundreds of thousands of dollars invested. If, however, stocks decline, you’ll have saved a lot of money by selling.
Technology stocks, did decline, and Sue asked if she should buy back the stock. I said no, now sell another quarter. If stocks rally, you will make money. If they fall, you will have saved more money. We continued this process until she completely exited her technology stocks. In the end she exited pretty close to the NASDAQ top of 5,000 and actually made money on her tech stock investments.
How can a decision to sell be good in both up and down markets? The answer is that it is a psychological trick. Obviously, the decision to sell stocks reduces profits if stocks rise afterwards. In the case of a stock market rally, I suggested that sister Sue savor the profits on the stocks she still owned, not the profits she hadn’t earned on the stocks that she had just sold.
The win-win framing of selling stocks is a form of irrationality. Nevertheless, such tricks can help us precisely because we are not completely rational decision makers. Our financial plans are often hurt by our irrationality; it is great to use irrationality to our advantage.
Owning a relatively small house also allows for a win-win outcome with the appropriate psychological framing. As always, I follow my own advice. My wife and I live in a Cambridge condominium worth a bit more than $600,000. We hope to have more children, and when we look out five or 10 years, we’d like to live in a larger place. The current cost of the house we expect to own is more than a million dollars.
I can make myself believe that we will make money in either a housing boom or bust. If prices rise, we make an additional capital gain on our current property. If prices fall, our dream house will decline in price by more than our current home. Thus, we will be able to upgrade to our dream house for less than it would cost today.
So own some property, but expect to move up in the future.
Solution #2: Have a Fixed-Rate Mortgage
My advice on adjustable-rate mortgages is extreme. In As Good As It Gets when Jack Nicholson’s neighbor (played by Greg Kinnear) swings by for a visit, Nicholson launches into a tirade:
Never, never again interrupt me. Okay? I mean, never. Not 30 years from now . . . not if there’s fire. Not even if you hear a thud from inside my home and a week later there’s a smell from in there that can only come from a decaying body and you have to hold a hanky against your face because the stench is so thick you think you’re going to faint even then don’t come knocking . . . don’t knock . . . not on this door. Not for anything. Got me. Sweetheart?
I paraphrase Nicholson to say, don’t get an adjustable-rate mortgage, not even if you are sure you will move in one year, not even if the adjustable-rate mortgage payment is much smaller than the payment for a fixed-rate mortgage. Not for anything.
There are actually at least three good reasons to have an adjustable-rate mortgage. First, real estate professionals may rationally want to take a gamble in the area where they are experts. This applies to my nephew Brent. If anyone is going to be able to get out at the top, it is likely to be a professional like Brent with his finger on the pulse of the market.
Second, adjustable-rate mortgages can be perfect for someone who knows she or he will sell soon. Consider, for example, a person who will move in two years and who has an adjustable-rate mortgage that is fixed for the next three years. For this person, an adjustable mortgage is almost as safe as a fixed-rate mortgage. (Even in this situation, adjustable rates are bit
more risky because plans change and the fixed-rate mortgage provides more flexibility.)
Third, people who have lots of financial reserves can use adjustable-rate mortgages. A central problem with an adjustable mortgage is that a homeowner may be forced to sell into a down market. If the homeowner has plenty of money stashed away for such a day, then there cannot be a forced sale. So people who can afford fixed-rate mortgages can afford to bet against the pros and not risk too much.
It is said that banks are willing to lend to anyone who doesn’t need the money. Similarly, adjustable-rate mortgages provide lower payments but should be used primarily by those who can most afford the higher payments of a fixed-rate mortgage.
So most, but not all, people should avoid adjustable-rate mortgages. My advice on this subject is precisely the opposite of that of Federal Reserve Chairman Alan Greenspan.19 In a speech on February 23, 2004, Chairman Greenspan noted that in the decade prior to his speech, those with adjustable-rate mortgages paid far less than those with fixed-rate mortgages. He also pointed out that adjustable-rate mortgages are far more common in some other countries. He concluded, the “traditional fixed-rate mortgage may be an expensive method of financing a home.”
I disagree with the chairman for two reasons. First, I believe that interest rates are likely to rise. Thus, when adjustable-rate mortgages come to their adjustments, I expect payments to increase.
Second, an adjustable-rate mortgage is a bet on interest rates. If rates increase by less than the market expects, you win with an adjustable rate. If rates increase by more than the market expects, you lose. Thus, those who choose adjustable-rate mortgages put their wealth at risk by betting on interest rates. Furthermore, that bet is taken against professionals.
My friend Greg used to bet against professionals of a different sort. He loved poker and used to test himself by playing against card sharks in Las Vegas. Because he was playing against pros, Greg expected to lose. He judged his ability by how long he could stay in the game before going broke. After one extremely successful evening, a pro took Greg aside and said, “You’re an excellent young player, but when you have a strong hand, your left jaw muscle tightens.” It was no surprise that Greg usually lost against such competent adversaries.
Competing against poker professionals was a losing game for Greg. Because he expected to lose, he never played for large stakes. He certainly would never have bet his house against professionals. Those who take adjustable-rate mortgages are betting their houses (or at least a substantial chunk of their wealth) against professionals.
Adjustable-rate mortgages are tempting because the payments can be so low. One day, while we were sitting in the Jacuzzi of our condominium, my neighbor Alec told me that he was moving out of Cambridge to a big house that he had purchased in the suburbs of Boston. As always, I asked, “fixed or adjustable mortgage?” Alec responded “adjustable.” When I asked why an adjustable-rate mortgage, Alec replied, “If we had a fixed-rate mortgage, we couldn’t afford the purchase.”
I would recommend precisely the opposite strategy. If an adjustable-rate mortgage is needed to make payments affordable, I suggest purchasing a less expensive property.
Make Your Money at Work; Live in Your Home
Real estate has been the path to riches in America. Housing prices have risen relentlessly for decades. Furthermore, the magic of leverage has allowed people to make incredible rates of return. Millions of Americans have made the bulk of their wealth through real estate.
Unfortunately, the easy money has been made. The housing market is expensive and has a number of structural risks. The path ahead will be less rosy than the path behind. If we are lucky, we can still have an expanding housing sector, albeit at a far more modest pace than in preceding decades. If we are unlucky, we may face persistently declining housing prices for some time.
Accordingly, I suggest that people return to Peter’s advice regarding housing. Buy a home that you plan to live in. Expect to make your money in the area where you are an expert.
I also suggest putting yourself into a position where you can withstand some housing market turmoil. Even if the more optimistic scenario unfolds, it is likely that there will be some severe shocks to the system. When such shocks occur, those with the strong financial hand will be in a position to scoop up some values. Those with the weak financial hand are likely to be shaken out of the market at the wrong time.
There is value in strength in many areas. I learned a variant of this lesson when I was living in Uganda. I rode my motorcycle to Queen Elizabeth Park in western Uganda. In the park, I met with John, a man who worked for the Jane Goodall Institute helping chimpanzees. When John learned that I had ridden my motorcycle through the game park he became quite concerned. “Are you good with the bike?” he asked. I replied that I had just learned to ride. He looked concerned. He said, “There are three types of animals to fear as you drive out of the park, and I have specific advice for each type.”
“First, stand your ground against elephants. They are more likely to give a mock charge than a real charge—of course be prepared to ride away as fast as possible if the charge gets too close. Second, never stand your ground against the buffalo. They never give mock charges, and it is better to be trampled than gored.”
“Third, lions are the toughest.” John became concerned at this point—“The trouble with lions is that by the time you see them it’s too late.” He went on to say, “Never ever back down from a lion. Once they sense fear they are all over you. Furthermore, never turn your back on a lion—they don’t like faces and when they eat people they tend to sit on the human’s face. They pick on weak animals so when the road goes through thickets where the lions hide, go fast and be loud, act like a strong and powerful animal.”
Act like a strong and powerful animal! I took John’s advice. Near every thicket I accelerated and drove the motorcycle at top speed. I also tried to keep the gear lower so that I could make more noise. I kept thinking, lions drag down the sick and old animals in the herd. Act like a powerful animal, and they will leave me alone. On the drive, I saw an elephant (I stood my ground and he walked away) and I outran a buffalo. I did not see any lions; if they saw me from inside the thickets, apparently they were impressed with my vigor.
My advice with housing is the same as John’s with lions. Be strong and powerful. Make sure that you can withstand some tough economic times. Those who can take the pain of a tough housing market put themselves in the position to profit from irrationality, not to become prey.
The Mean Markets and Lizard Brains advice with regard to housing is to do the opposite of what has worked—have a fixed-rate mortgage and own a smaller home than you plan to have in the future. Taking these steps is very hard because it requires overriding the lizard brain. For decades the best strategy has been to buy as much U.S. real estate as possible and ride the rocket ship to riches. Our backward-looking lizard brain prods us to do what has worked in the past. In order to position ourselves for trouble, however, we have to avoid the course of action that has worked for generations. Those who can accomplish this psychologically difficult task put themselves in a great position to profit.
Update since the First Edition
U.S. home prices have stopped rising. In 2007, U.S. housing prices, as measured by the Office of Federal Housing Enterprise Oversight (OFHEO), saw their first nationwide decline since the creation of comprehensive price indices in 1975 (Figure 9.8). Based on less comprehensive data from before 1975, U.S. housing prices appear to have increased every year between World War II and 2007. Therefore, 2007 was the worst year for U.S. housing prices for somewhere between 30 and 60 years.
From this perspective, can we say that housing was in a bubble, and has the bubble now burst? I think not. As measured by the OFHEO, the 2007 decline in U.S. houses was a scant 0.3%. Other measures of housing price declines are more severe. For example, the S&P/Case-Shiller index documents a 9% decline in U.S. housing for 2007. A 9% decline is very small as
compared with true bubbles such as the Dutch tulip bulbs (100% decline), Nasdaq in 2000 (80% decline) or Dow in the 1930s (90% decline). Furthermore, one has to be extremely negative to predict a world where U.S. house prices will decline by 50% in total from peak to trough, which would still be smaller than many bubbles.
FIGURE 9.8 U.S. Housing Prices Have Stopped Rising
Source: Office of Federal Housing Enterprise Oversight
What’s Next?
Is there more bad news ahead for U.S. housing, or have the last few years of housing market pain prepared us for another good period? More pain is the short answer. We have not unwound the excesses of the last 60 years. The psychology on housing is not positive, but has not become negative enough for long enough to signal a turnaround.
Beyond psychology, two macroeconomic trends appear negative for future housing price gains. First, the price declines have been very modest, and have reversed only a small fraction of the increases. Thus, if valuations are to return to historical averages, there is a considerable further decline to come. Second, all the bad news in housing has come in a very benign interest rate environment. Mortgage rates are still near multidecade lows, and real interest rates are negative. If nominal or real interest rates rise, housing prices will go down significantly.
Mean Markets and Lizard Brains Page 24