Gary and I each acted upon our beliefs. I invested every dollar I had into stocks, while Gary developed an aggressive system of acquiring real estate. As soon as he could scrape together a down payment, he would buy a rental property. He would then squeeze every possible penny out of the rents and minimize costs (he even went so far as to do the weekly cleaning of his beach properties himself—I always pictured him in a wet-suit and a maid’s outfit). As soon as he amassed enough cash for another down payment, Gary would buy another property to increase his empire.
So who was right, Terry or Gary? In the early 1980s, was it better to have invested in stocks or in southern California real estate? Stocks have gone up by more than 1,000% while land values have steadily increased, but at a slower rate. So does that mean I was right? No. As we discussed in Chapter 9, real estate allows much higher leverage than stocks. Thus, Gary’s aggressive—buy as much as you can with borrowed money—strategy earned him a far higher rate of return than was possible in the stock market.
While Gary and I were both bored by bonds, they too provided very strong returns. In 1980, an investment in bonds, particularly a risky investment in long-term bonds, would also have been richly rewarded.
In the early 1980s, picking the right investment was easy. Stocks, bonds, and houses all soared. The only possible mistake, therefore, was to avoid financial risk. For an entire generation, risk was richly rewarded. The only way to lose, it turned out, was not to play. So if Adam were asking his question in 1980 the answer would be clear—borrow as much money as you can, take as much risk as you can stand, and rake in the cash. The conventional wisdom says that risk is still the right course for patient investors who seek high returns. But is it?
The Bull Market of a Lifetime?
The famous Chinese “curse” says “May you live in interesting times.” The quirky aspect of human nature is that we are built to expect that our own idiosyncratically interesting times are simply normal. The international man of mystery, Austin Danger Powers, experienced a variant of this problem.
In 1967, Austin Powers (played by Mike Myers) was cryogenically frozen to prepare for the day that archvillain Dr. Evil (also frozen, and also played by Mike Myers) might once again threaten the world. Decades later, Austin was thawed when this threat materialized. Elizabeth Hurley, playing “minx”-like agent Kensington, became the partner of our recently defrosted superspy.
Agent Kensington introduces herself, “Mr. Powers, my job is to acclimatize you to the nineties. You know, a lot’s changed since 1967.”
Austin replies, “No doubt, love, but as long as people are still having promiscuous sex with many anonymous partners without protection while at the same time experimenting with mind-expanding drugs in a consequence-free environment, I’ll be sound as a pound!”
The joke, of course, is that the norms of the 1960s regarding sex and drugs had become abnormal by the 1990s. This is not unique to the 1960s. Modern societies change very rapidly, and we are built to be perpetually behind the curve, thinking that this generation’s fad is a permanent feature of human existence.
Like other aspects of human nature, our tendency to underestimate change may reflect our ancestral past. For tens of thousands of years, at least up until the invention of agriculture, our ancestors lived in a world where many important attributes never changed.
Our human tendency to expect that the future will be like the past may have helped our cavemen and cavewomen ancestors, but it does not work well in a rapidly changing modern society. It works even less well in financial markets where today’s fad is likely to be tomorrow’s loser. Recognition of the current situation is crucial, as my friend Matt discovered.
A few years ago, Matt had a romantic dinner in Budapest overlooking the Danube River. A violinist approached the table while playing enthusiastically. After he completed the piece, the musician asked Matt if he had a request. Suave and confident in front of his date, Matt said, “How about the ‘Blue Danube’?” The violinist responded, “That was it.”
Similarly, if we had the chance to request an investment climate, we might ask for a massive bull market in stocks, bonds, and real estate. We would love a setting where financial risk was rewarded almost without regard to the type of investment (even surfers could get rich in such an environment). To which the reply would have to be, “That was it.”
We have just lived through an atypical and unsustainable financial period. In recent decades, stock prices have risen at almost three times their natural speed limit. Similarly, interest rates have fallen toward zero, fueling the real estate market with cheap mortgages. Finally, with our massive trade deficit we are racking up enough debts to make Uncle Sam an international beggar.
None of these trends are sustainable. By themselves, however, the required changes do not mean doom and gloom. Theoretically, stock prices can rise indefinitely (albeit at a slower pace), interest rates can remain low (even if they can’t decline much further), and our adjustment to a trade surplus can lead to greater employment (even if this means lower real wages).
The danger lies not in the macroeconomic adjustments we face, but in our psychology. Just as the fleeting nature of the 1960s culture surprised a defrosted Austin Powers, we are not built to recognize the unsustainable facts about our world. It is an economic truth that the financial future must be different and worse than the fantasyland of the past generation. It is a psychological truth, however, that most of us will realize this change only after it has occurred and when it is too late to find profits.
The current financial environment is kryptonite for the lizard brain. Just as Superman was really only vulnerable to kryptonite, the lizard brain gets us in particular trouble when powerful trends must end. The backward-looking lizard brain is literally surprised when patterns don’t repeat. The golden generation of rewarding risk has set us up for financial losses. Because our lizard brains are set up to collide with economic necessity, these are the meanest of markets.
Is It Time to Take Less Financial Risk?
“When you have eliminated all which is impossible, then whatever remains, however improbable, must be the truth.”—Sherlock Holmes
In answer to Adam’s question, Mean Markets suggests that none of the big three investment alternatives—stocks, bonds, and real estate—is likely to provide great returns. Based on macroeconomic analysis these traditional investments range from fairly valued to expensive. Importantly, none of them appear to be cheap.
While none of these investment alternatives looks cheap, standard economic analysis doesn’t find any of them to be wildly overpriced, either. Therefore, one might conclude that we will see a relatively benign investment world.
The science of irrationality, however, reaches more pessimistic conclusions. We are built to do that which has worked, and we have just lived through an extraordinary period that rewarded financial risk. Furthermore, the single best guide to future performance is to bet on that which is unloved. Wall Street, Main Street, and both neoclassical (the “rational” school) and behavioral economists (the “irrational” school) are betting that risk will be rewarded.
In The Adventure of the Silver Blaze, Sherlock Holmes solves the case in an unusual manner. Holmes’s colleague, Inspector Gregory, asks, “Is there any other point to which you would wish to draw my attention?” Holmes responds, “To the curious incident of the dog in the night-time.” Inspector Gregory protests, “The dog did nothing in the night-time.” To which Holmes concludes, “That was the curious incident.”
Sherlock Holmes solved the case because of the “dog that didn’t bark.” Similarly, the Mean Markets conclusion is that the best financial approach today might be to reduce risk. This is the opposite of the conventional wisdom. The very core of the efficient markets hypothesis is that investors who want high returns must accept high risk.
The “investment that doesn’t pay today” may solve the current financial dilemma. Because markets are sometimes wildly irrational, the “reward only
for taking risk” equation can be reversed. The analysis of this book suggests that now is one such time. Low-risk investments, even those that pay close to nothing today, may be the long-term road to wealth.
Financial success might require hunkering down in a low-risk posture until markets become irrationally cheap. When the financial world is filled with pessimism and others are selling their risky assets, those savvy investors who are prepared will be able to scoop up bargains.
Thus, the Mean Markets and Lizard Brains answer to Adam’s question is that each of us should reduce our financial risk to a level far below where we feel comfortable. Our lizard brains have been fooled by the last 20 years of unsustainable gains. Thus, it is likely that we are all walking around with overly optimistic views of the world. We are taking more financial risk than we think we are, and most of us are taking more risk than we would want if our lizard brains allowed us to see the world clearly.
For those who want to take the Mean Markets and Lizard Brains advice to reduce financial risk, here are eight steps that can be taken immediately.
Risk Reducer #1: Allocate More Money to Lower-Risk Assets Sell some stocks. Shift some money from growth stocks to value stocks. Increase holdings of cash and short-term securities.
Risk Reducer #2: Buy Some Inflation and Deflation Protection
Buy inflation-protected bonds in the form of Treasury Inflation Protected Securities (TIPS) or Series I U.S. savings bonds. Buy the stocks of companies that make the products that might go up in price (e.g., drug companies, oil companies).
Risk Reducer #3: Buy Short-Term Bonds
Buy bonds that mature soon; sell longer-term bonds.
Risk Reducer #4: Live in a Smaller House
Own a house that is less valuable than the one you plan to live in five years from now.
Risk Reducer #5: Have a Fixed-Rate Mortgage
Variable-rate mortgages are risky.
Risk Reducer #6: Invest in Other Currencies
Buy bonds that pay European euros or Japanese yen. Buy stock in companies that make a lot of money outside the United States.
Risk Reducer #7: Pay Off Your Debts
Rewards go to those with strong financial structures able to withstand (and profit from) adversity. Reduce your debts to build a strong hand.
Risk Reducer #8: Seek a Secure Paycheck
Now might not be the best time to leave a boring but safe job in order to start a restaurant or work for a start-up company.
The Risk of Low-Risk Investing
The Mean Markets recommendation to reduce financial risk is grounded in three macroeconomics truths:1. Stock prices cannot grow faster than the economy forever.
2. Interest rates cannot go below zero.
3. The United States cannot run a trade deficit forever.
While these three are facts, picking the correct investments to profit from these changes is an exercise in economic forecasting. As we all learned, economic forecasts often boldly go to incorrect conclusions.
In the Foundation series of science fiction books, Isaac Asimov tries something far more difficult than economic forecasting. Asimov suggests that the field of “psychohistory” can predict the future of society. Psychohistory is “that branch of mathematics which deals with the reactions of human conglomerates to fixed social and economic stimuli.” Psycho-historians claim that while individual behavior is unpredictable, social trends can be forecast based on the laws of probability.
Asimov’s fictional psychohistorian, Hari Seldon, correctly predicts events for hundreds of years. Long after his death, the great Seldon’s prerecorded comments are played to generations of leaders on a secret schedule, and his accuracy would make even Nostradamus envious. Then, directly in opposition to Seldon’s predictions, the Foundation is conquered.
Even in a novel, forecasts tend to be wrong! How did Asimov’s hero fail? The answer is that the Foundation’s conqueror is a mutant called “the Mule.” Based on probability, the chance of such a leader’s arising was so small that the laws of psychohistory could not anticipate such an unlikely turn of events.
Interestingly, Wikipedia, an online encyclopedia, lists macroeconomics as a “see also” topic under the description of Asimov’s psychohistory. Like psychohistory, economic forecasts are particularly bad at anticipating the effect of novel and unlikely events. If there is to be such a “mule”-like event within economics, it is the productivity increase that is possible because of information technology.
Everyone has been touched profoundly by information technology. My own personal stories stretch from “knowledge-work” to manufacturing. The Harvard Business School now uses an electronic course platform to coordinate all teaching activities and distribute materials to students. This has made my life as a professor vastly easier. All of my lectures are electronically uploaded to the web from my office and accessed in the classroom. Printed material is distributed to hundreds of students with the literal click of a button.
More concretely, my father-in-law, Joel, works for an American company that actually manufactures something—very high quality flashlights (some costing hundreds of dollars). I visited the flashlight factory and found a giant room with a bunch of intelligent machine tools and three people. The people maintain the machines and feed them raw materials. With the right tools, three people can make a huge number of flashlights.
Everybody has similar experiences, and many are more dramatic than mine. Day by day, and in countless ways, information technology is making it easier to produce goods and services. As foreseen by the great economist John Maynard Keynes, productivity increases driven by information technology hold the promise of allowing humans to combine leisure with material excess.
Productivity thus holds the potential to cure America’s financial woes. Many of those most pessimistic about our financial future point to the massive debts we have both as individuals and through our government. For example, market seer Bill Gross of PIMCO is on record with his prediction that the Dow Jones Industrial Average will decline to 5,000.1 One of the reasons that Mr. Gross cites for his pessimism is a total U.S. debt level that—measured against the size of the economy—is the largest in history, exceeding even the bubbly 1920s.
Similarly, Robert Prechter (of Elliot Wave fame) cites similar debt statistics in many of his works, including his 2003 book Conquer the Crash. Mr. Prechter sees the possibility for the Dow to return to 1,000 or lower, making Bill Gross seem optimistic.2
Debt levels are indeed high. Furthermore, many aspects of our indebtedness are relatively new. The first “plastic” money, for example, was invented only in 1950, and widespread use of credit cards didn’t take off until the invention of the magnetic strip in the early 1970s.3 Now that credit cards are ubiquitous, almost everyone drags around a hungry debt balance that requires constant feeding. We are acclimatized to think of such indebtedness as natural. Scholars of irrationality and cycles, however, point out that credit junkies can convert to frugality with chilling economic effects. Thus, the indebtedness of our society threatens our prosperity.
Just as a highly unlikely event surprised the laws of psychohistory, abnormally high levels of productivity can protect us from the seemingly inevitable consequences of our indebtedness.
Through a similar lucky event, I survived a bout of indebtedness some years ago. While I was a student getting my Ph.D., Progenics Pharmaceuticals—the company that I had helped start, and for which I had served as president and chief financial officer—prepared for its initial public offering (IPO). With this event, I would be able to sell my shares and switch from bicycle-riding student to millionaire.
Because I know that markets are fickle, I resolved not to count my chickens too soon. Or at least not to spend them. So my goal was to act as if I were still poor until the cash hit my bank account. This, of course, proved impossible. In almost every conceivable way my expenses crept up. I took cabs, bought extra appetizers at meals, and flew to New York instead of taking the train. These ex
penses added up to some thousands of dollars of debts. Not to worry, soon the money would roll in.
After some months of trying to sell the IPO without much interest, Progenics decided to abandon its public offering. I was left with my debts and stock that I could not sell. About a year later, and after some business successes, Progenics restarted the IPO process. Once again I resolved to remain frugal in the face of my impending wealth, and once again I failed. Fortunately, this time the company went public, and I was easily able to pay off my debts.
If productivity growth can continue at its abnormally high pace it may do for the country what Progenics’ IPO did for me. If we are all going to be much, much richer because of information technology, then it makes sense to spend some of our windfall in advance. The high levels of debt in our society, and even the high level of our trade deficit, can be seen as the logical pre-spending of our future wealth.
Mean Markets and Lizard Brains Page 29