How to Make Any Investment Unreasonably Risky
#stayrich Debt is dangerous, even if it isn’t yours.
We love repeatability. Take anything that’s good. Do it more. Do it again. Scale it. Do it bigger and better and more and more. More is better, right?
Take the home real estate market. Until 2009, the expression “safe as houses” lacked any hint of irony. Or take the recent SVB (Silicon Valley Bank) mini-crisis. SVB went bankrupt by investing in “risk free assets,” US Federal Treasuries. Losing money on those is supposed to be literally impossible!1 Venturing farther into esoteric markets, in cryptocurrency, crashes have happened repeatedly when investorsgamblers use automated markets to post collateral and borrow more crypto, which they post as collateral and borrow still yet more crypto. All of these examples have a single thing in common: debt.
In the early 2000s, people started taking out NINJA loans (no income, no job, accepted!) to buy real estate. They loaded up on interest only loans. But worse than that, they moved from traditional 20% down loans to 10%, then 3%, then 0%, and in some exotic cases, loans where the borrower received a check at closing! What’s the worst that could happen? The bank figured they could always foreclose, sell the house for a profit, and screw over the borrower. After all, home prices always go up, and never go down. They especially never go down in hot markets, and they especially never go down in all the hot markets simultaneously across the entire country. I think we know how that ended up.
Over a decade later, Silicon Valley Bank took their depositor’s money, turned around, and invested it into long term US government bonds. Those long bonds paid a higher rate than short term bonds, and yes, long bonds could theoretically lose value if the Fed raised rates, but the Fed would have to raise rates suddenly and enormously for SVB to go bankrupt. Yes, they had borrowed a ton of money from their depositors, but rates had literally never risen that fast and that much in the entire history of the USA! It was impossible to lose money! Well, impossible right up until the moment when it happened.
So what’s the lesson here? Debt is dangerous, even if it isn’t yours. In the Great Financial Crisis of 2009, it didn’t matter whether your home was free and clear, or had a nice, responsible 20% down mortgage, or you bought it with a crazy cash out NINJA loan. The neighbors were all busy gorging themselves on insane levels of debt, and when the market crahed, all the home values cratered together. The SVB depositors got bailed out by the FDIC, the Fed created a “special facility” to prevent the panic from spreading, and we’re all paying for it through fees at our banks and slightly higher inflation. The Bitcoin investors in 20182 who bought and held still lost value on their coin, even if it came back a few years later.
The fact that there was short term money to be made with irreponsible debt, at scale, was the thing that caused the crash! Home values would never have crashed if that debt never happened. In the case of SVB, it wasn’t big enough to move interest rates up all by itself. But the same conditions that made it seem like a great idea to borrow all the money from depositors and dump it in long bonds also caused the Fed to spike interest rates.
So ask yourself; which of your investments are levered up? What is your debt load? What would you do if you had a cash flow crunch? How would you make your payments? This is a normal level of prudence.
What investors fail to do, over and over and over again, however, is ask these questions about the entire market, thus making debt dangerous. So now I want you to go back and ask yourself a different question. Which of your investments are in things where the levels of debt across the market are high and rising? Which of your co-investors or counterparties (the people/entities who owe you money) are going crazy with debt?
Debt causes crashes. Look under the hood of any market bubble,3 and you’ll find people borrowing like there’s no tomorrow. Look under the hood of any bubble popping, and you’ll find that debt going bad. Any investment can be risky if enough debt is involved.
As rich people, we basically are immune to financial problems, as long as we stay rich! You know what’s better than making a ton of money and then losing it all in a hot market? Making way less money and not losing it all! Any investment, no matter how “safe,” can be made absurdly risky with enough debt.
On the other hand, the “right”4 thing to do if you know market is in a bubble might be… nothing. Alan Greenspan correctly called the tech bubble in 1999 in a speech broadcast to the world. Of course, stock market investors who got out in 1999 missed the crash, but they also missed out on all the gains between 1999 and 2001, and the gains were larger than the crash! The “right” thing to do was not just nothing, it was to keep buying!
For veteran cryptocurrency investors, the mania and hype that preceed any crash are so predictable at this point that people make roller coaster memes about it. And the “best” way to make money in that market historically has been to do as little trading as possible on the very best coins, with no leverage, and hold for as many years as possible. People who ignore the booms and also ignore the busts generally outperform the people who try to time the market, in almost every market!5
So what do we do? Ignore rising debt levels, or trade on them? The answer, as usual, is nuanced. It won’t hurt to be aware when a market is in a mania. Don’t get caught up in the mania, and you’ll avoid the FOMO (fear of missing out) that might cause you to panic buy. You’ll feel smug and justified when the market crashes later, and that feeling will help prevent you from panic selling during the low times. At the same time, having an understanding of the broader levels of debt in a market will help you identify things that might just be completely mispriced, and that will help you find deals and avoid disasters. Stay rich, friends.
See, there’s always a footnote with these things. Losing money by investing in US Tresuries is indeed impossible if a long list of rare things never happen, you don’t count inflation, and you hold the Treasuries until they mature in a few decades. If you have to sell them early, and rates rose fast enough over the course of the time you held the bond, you might lose money. But who ever needs to sell an investment early? Oh, wait. Anyone could end up in that situation!
And 2022, and 2021, and 2014, and 2012, and 2010…
You might have to look pretty deeply, though. How many people in 2007 knew what a collateralized debt obligation on a mortgage backed security was unless they were one of the people making money from the business of selling all those bad loans? The finance industry loves complexity.
I’m using scare quotes for a reason. The right thing for me is probably not the right thing for you, because we are different people with different spending needs and preferences and emotional ability to handle the booms and crashes. But you’d never take something you read on the internet and go blindly follow that like a recipe without using your brain and doing due diligence, right? Right?
https://www.ncbi.nlm.nih.gov/pmc/articles/PMC8695249/ “…the most active traders perform worse than less active traders even on a gross excess return basis.” This is about the stock market, but the principles generally hold in other markets as well.
There are two main reasons for this: tax drag, because Uncle Sam mostly won’t tax you until you sell, and trading fees, coupled with the fact that most markets are generally going up over the long run, but every dollar made in a short term trade is a dollar someone else lost. That means that the shorter term your thinking is, the more you are playing poker at the casino and needing to beat the rake on every session, while the longer term your thinking is, the more you benefit from humanity generally getting richer over time.