The late economist Hyman Minsky developed an economic theory in the 1960s that argues “stability begets instability.” The more things remain the same, the more they are likely to change, and change with punishing magnitude, to distill the theory to a sentence.
History proves that Minsky’s insight is neither novel nor new. Humans from the time of Genesis have demonstrated a propensity to end the good times with a rousing screw-up. The nineteenth-century novelist Fyodor Dostoevsky was more observant and more nuanced than most in explicating this propensity.
Returning to modernity, Minsky’s core idea distills to one concept: the longer equity markets feel stable and prosperous, the longer prices trend higher, the more investors are willing to embrace risk, most of it financial, the more likely investors will experience a rousing screw-up.
Investors increase borrowing to invest in the extended upward price trend of their favorite stocks. Concurrently, investors reach for yield, which trends negatively with stock prices. They allocate more of their portfolio into firms that themselves are accumulating apparently low-risk debt.
Never forget that leveraged investors are prickly investors. They might be cavalier when accumulating and leveraging their investments; their diligence in monitoring the trend rises in lockstep with their leveraged investments.
Wealth builds over time similarly to the time a roller coaster requires to ratchet upward, notch by notch, to the apex. And like a roller coaster, wealth dissipates as thunderously and with similar immediacy as the roller coaster that has breached the apex. A few prickly investors sell, more prickly investors glom onto the emerging trend, the momentum steamrolls into a freefall.
A harrowing deflation ensues. Lenders, formerly as liberal in lending as any simpleton Hollywood B-star poiser is spending your money, suddenly turn monastic. The money supply shrinks; money owned by individual and businesses is hoarded. Prices everywhere fall as more people convert goods, services, assets, and investments into an evaporating (and rising value) pool of dollars.
Debt is always converted to equity, through either amortization or default. Vast amounts of debt are converted to equity through default. Many investors recoil into themselves to contemplate their contriteness. Everyone is cautious. Everything grinds to a standstill.
Time passes, as it always does, and so does the dour milieu. Investors step out, with baby steps at first, of themselves. Green shoots of optimism appear, growth returns to the economy, Wealth begins to ratchet, notch by notch, higher once again. Prices rise. As prices rise, more investors are emboldened to enter the market.
This cycle of boom to bust is as inevitable as the cycle of night to day. (Advocates of the Austrian School of economic might beg to differ. They believe is boom/bust cycle less inevitable as the night/day cycle. The expansion and contraction of a fiat money supply causes the boom/bust cycle. That said, the reality is an expanding and contracting fiat money supply. But I digress.)
The good news is that you can accumulate wealth over time while you endure the inevitable booms and busts, the stability into instability..
The peek of the next boom nearly always exceeds the peak of the previous boom; the trough of the next bust is unlikely to fall to the trough of the previous bust. The trough could even bottom before the previous peak.
Most of us dislike the stock-market roller-coaster. For those who do, they can build wealth and mitigate the dyspepsia-inducing cycling between boom-and-bust (stability and instability) by following a few simple rules.
Remaining invested is the first rule. No one gets hurt on a roller-coaster unless he attempts to disembark mid-ride. Remain invested as equity prices descend into the trough. Unlike the roller-coaster trough, you’re unable to see the trough of the market sell-off. Conversely, you’re unable to perceive when the upward ratcheting toward the next peak takes hold.
Stay invested, stay invested in a diversified stock portfolio. (I offer a diversified portfolio recommendation in this blog post.) Stocks are risky. A concentrated portfolio is a risky (or riskier) portfolio. The stocks that powered the last boom are unlikely to power the next.
The diversified stock portfolio will be free of leverage, of course. Leverage will induce you to sell. Like the roller-coaster rider who disembarks mid-ride, you will get hurt, and possibly beyond recovery.
I extend my leverage admonition to all matters of finance, personal or business. The bust is frequently instigated by a Black Swan: the pandemic being the latest example; the implosion of the financial sector in 2008 being the previous example.. Debt – your debt – will only exacerbate your panic and impulse to sell. It will expose your vulnerability. It will motivate you to rousingly screw-up.
Always hold cash. Cash is a buffer. It enables you to endure difficult times. It enables you to exploit the opportunities that follow. Cash serves a purpose similar to a climber's rope. Can it be said that the rope on which the climber carries is of service only when looses his grip? No, without the security the rope provides, the climber will forgo the climb. Without the security of cash on hand, you will lack the security to exploit the new investing opportunities the bust presents.
History proves that Minsky’s insight is neither novel nor new. Humans from the time of Genesis have demonstrated a propensity to end the good times with a rousing screw-up. The nineteenth-century novelist Fyodor Dostoevsky was more observant and more nuanced than most in explicating this propensity.
Returning to modernity, Minsky’s core idea distills to one concept: the longer equity markets feel stable and prosperous, the longer prices trend higher, the more investors are willing to embrace risk, most of it financial, the more likely investors will experience a rousing screw-up.
Investors increase borrowing to invest in the extended upward price trend of their favorite stocks. Concurrently, investors reach for yield, which trends negatively with stock prices. They allocate more of their portfolio into firms that themselves are accumulating apparently low-risk debt.
Never forget that leveraged investors are prickly investors. They might be cavalier when accumulating and leveraging their investments; their diligence in monitoring the trend rises in lockstep with their leveraged investments.
Wealth builds over time similarly to the time a roller coaster requires to ratchet upward, notch by notch, to the apex. And like a roller coaster, wealth dissipates as thunderously and with similar immediacy as the roller coaster that has breached the apex. A few prickly investors sell, more prickly investors glom onto the emerging trend, the momentum steamrolls into a freefall.
A harrowing deflation ensues. Lenders, formerly as liberal in lending as any simpleton Hollywood B-star poiser is spending your money, suddenly turn monastic. The money supply shrinks; money owned by individual and businesses is hoarded. Prices everywhere fall as more people convert goods, services, assets, and investments into an evaporating (and rising value) pool of dollars.
Debt is always converted to equity, through either amortization or default. Vast amounts of debt are converted to equity through default. Many investors recoil into themselves to contemplate their contriteness. Everyone is cautious. Everything grinds to a standstill.
Time passes, as it always does, and so does the dour milieu. Investors step out, with baby steps at first, of themselves. Green shoots of optimism appear, growth returns to the economy, Wealth begins to ratchet, notch by notch, higher once again. Prices rise. As prices rise, more investors are emboldened to enter the market.
This cycle of boom to bust is as inevitable as the cycle of night to day. (Advocates of the Austrian School of economic might beg to differ. They believe is boom/bust cycle less inevitable as the night/day cycle. The expansion and contraction of a fiat money supply causes the boom/bust cycle. That said, the reality is an expanding and contracting fiat money supply. But I digress.)
The good news is that you can accumulate wealth over time while you endure the inevitable booms and busts, the stability into instability..
The peek of the next boom nearly always exceeds the peak of the previous boom; the trough of the next bust is unlikely to fall to the trough of the previous bust. The trough could even bottom before the previous peak.
Most of us dislike the stock-market roller-coaster. For those who do, they can build wealth and mitigate the dyspepsia-inducing cycling between boom-and-bust (stability and instability) by following a few simple rules.
Remaining invested is the first rule. No one gets hurt on a roller-coaster unless he attempts to disembark mid-ride. Remain invested as equity prices descend into the trough. Unlike the roller-coaster trough, you’re unable to see the trough of the market sell-off. Conversely, you’re unable to perceive when the upward ratcheting toward the next peak takes hold.
Stay invested, stay invested in a diversified stock portfolio. (I offer a diversified portfolio recommendation in this blog post.) Stocks are risky. A concentrated portfolio is a risky (or riskier) portfolio. The stocks that powered the last boom are unlikely to power the next.
The diversified stock portfolio will be free of leverage, of course. Leverage will induce you to sell. Like the roller-coaster rider who disembarks mid-ride, you will get hurt, and possibly beyond recovery.
I extend my leverage admonition to all matters of finance, personal or business. The bust is frequently instigated by a Black Swan: the pandemic being the latest example; the implosion of the financial sector in 2008 being the previous example.. Debt – your debt – will only exacerbate your panic and impulse to sell. It will expose your vulnerability. It will motivate you to rousingly screw-up.
Always hold cash. Cash is a buffer. It enables you to endure difficult times. It enables you to exploit the opportunities that follow. Cash serves a purpose similar to a climber's rope. Can it be said that the rope on which the climber carries is of service only when looses his grip? No, without the security the rope provides, the climber will forgo the climb. Without the security of cash on hand, you will lack the security to exploit the new investing opportunities the bust presents.
RSS Feed