Understanding Stability

If you find yourself in either of these mindsets right now, we hear you. The effects of the coronavirus on our financial lives are beyond what we expected. However, what if there was another way to wrap our minds around this fear and confusion? Extreme times are an opportunity to learn about the investment world, but also about ourselves.

Today, we’re digging into the concept of stability in the markets. What happens when we have a steady growth in prices? How does it make us behave as investors? And what has history taught us about what happens following a period of stability?

Hyman Minsky was an American economist. He is best known for his research on the nature of a financial crisis. Minsky’s theories gained popularity following the 2008 Great Recession.

It seems counterintuitive. In order to understand his statement, we need to step back and look at the concept of stability and how it can affect our behaviour.

Stability is a period of steady growth and low volatility. When you experience an investment cycle where prices are moving upward, you start to believe it will always be that way. You start to feel safe, confident that this period of peace is here to stay. From a place of peace and confidence, humans tend toward more risk. Why not? I’m in a safe place, we say.

Stability encourages additional risk-taking behaviour — so people invest more. When they see success, they invest a little bit more, and then a little bit more after that. This process continues until we reach a tipping point. Suddenly, a small trigger can cause everything to collapse.

It’s not fair, right? A stable environment should mean we’re strong enough to handle small triggers. The error here is mistaking stability in prices for a strong foundation. The amount of risk was not necessarily based on strong fundamentals, but instead on the “feeling of safety and peace”.

Risk is defined as the chance that your investment outcomes will be different than what you expected.

Let’s look at an example where society “took more risk”. When you buy a house, you borrow money (your mortgage) in order to pay for it. In this case, you are borrowing money to invest in an asset. You are hoping, over time, the value of the asset will grow and the price you paid to borrow that money will be worthwhile.

Of course, borrowing money has rules around it. Mortgage rules exist to protect ourselves, the lender and the economy from taking too much risk. However, when house prices are increasing steadily over many years, we start to forget about the risk. We hear things like “real estate is always a good investment; it always goes up”. So, we lend a little bit more, take a little bit more risk. After all, there is very little danger here. Real estate is a safe investment, right?

Unfortunately, the more we rely upon borrowed money (or leverage*), the more fragile, or risky, our investment becomes.

How does leverage increase risk?

Well, we have a very clear example where increased leverage led to a different outcome than most people were expecting.

Let’s dig into the 2008 collapse of the US housing and stock markets. To really understand what happened, we need to go all the way back to the early 2000s. In response to 9/11, the government lowered interest rates dramatically to stimulate the economy. Lower interest rates resulted in lower borrowing costs which made it easier for people to buy things like a house.

And this is when we started to see the beginnings of what turned into a real estate bubble.

Once home prices started to rise, investors and the institutions that lent to them (like banks) started to get very excited. The belief that home prices could only go up became a widespread belief. So what did people do? They bought real estate and sometimes, lots of it. And the more prices went up, the more lenders were happy to extend credit. Lenders often didn’t even care who they were lending to. It reached a point where people could get a mortgage without having to prove they had the income to support the purchase. This made it possible for people to own multiple homes when they probably couldn’t even afford one. And in the worst-case scenario, if someone really needed to sell, they just assumed they could do so at a higher price, payback whatever debt they owed and pocket the rest. It was a sure way to riches.

As people took more risk, the markets became increasingly fragile. As we mentioned before, this period of stability was not built upon true strength. Lending money to people who can’t afford to pay it back is not good policy. When they couldn’t pay it back, it started a wave of selling that triggered the housing market collapse.

Can you start to see how stability might breed instability?

So, what now? How can we apply this concept going forward?

In the last month, we have seen “unprecedented” moves in the market that shocked almost everyone.

Because…stability breeds instability. And markets have been very stable for a long time.

For the last decade, governments have done everything in their power to suppress risk by keeping interest rates close to zero. A zero-interest-rate policy means that people are not rewarded for saving. Why keep money in the bank if it doesn’t earn you anything? Instead, it encourages people to start investing in things like the stock market or real estate. When the government made the world feel less risky, peace and confidence returned, and with it, began an upward trend in price. As prices started to rise, more people felt compelled to invest, which pushed prices up further and the cycle continued…

In many ways, the governments’ actions were very effective, but as the saying goes, “there is no free lunch in life”. This was no exception.

The costs of suppressing risk were significant. Asset bubbles were created, meaning, assets like real estate and stock prices were higher than they should be. These bubbles were created because the illusion of stability led people to underestimate the risk. They truly believed that nothing bad could happen.

Now, something very bad has happened. The actions over the last 10+ years made the currently very bad situation much worse than it would have otherwise been.

The markets are down and there is panic.

So did anyone see this coming?

Some people did manage to preserve wealth during this crisis. They are the ones who recognized that the markets were vulnerable. They were better at “pricing risk”. In other words, they saw the potential for instability when the rest of the market did not. Instead of risking all their money, maybe they kept some cash on the side and only invested some of it. These are the investors who will emerge from this crisis as winners. They can buy when everyone else is selling. They did not get tempted by the illusion of stability.

It’s too late for me now, right?

You are probably reading this and thinking that this is great information, but it’s easy to recognize in hindsight. You needed to know this before the market went south.

Minsky’s wisdom is always applicable. There are still some markets that seem stable because they have only gone up. Some argue that the Canadian housing market is one of them.

When we recover from this downturn, the same investor behaviours will begin again. It’s human nature. Your goal should be to reflect on Minsky’s wisdom and to apply it going forward.

Whether a market is in bubble territory or not can always be debated. Instead, focus on how the market is pricing risk. Are people basing their decision making on the fact that prices have always gone up? Are they taking more risk than they normally would? Or should? These are warning signs. It shows that they are operating under an illusion of safety — which we now know attracts risky behaviour. That risky behaviour makes markets more unstable.

So be on the lookout for this dynamic when you’re investing. And if you observe it, be prudent with your money, there is more risk than meets the eye. Don’t invest based on blind faith that prices will only go up because they have in the past. They can go down and stay down. So be thoughtful as to how you price risk.

Remember, stability breeds instability….

*A note on the concept of leverage: Let’s consider two scenarios: buying a $1m house with no debt (i.e. 100% equity) and buying the same house with 90% debt (i.e. 10% equity). What happens to our return if home prices dropped by 5% the day after we purchased our home?

In the first scenario, our house (i.e. our asset) dropped in value by $50,000. On our $1m equity investment, this resulted in a loss of 5%. Since we used no debt to buy our home, the return on the asset equals our return on our equity.

In the second scenario, our house also dropped in value by $50,000. However, in this case, we funded our purchase with 90% debt or $900,000. So on our $100,000 equity investment, we lost $50,000 or 50%.

The use of borrowed money, as we can see, magnifies the return on our investment proportional to the amount of leverage we use. The more leverage, the riskier the investment.

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