Twin Cities Business, Personal Finance, November
2007, By Jeff Dekko
Just as the markets were buckling in mid-August
under the threat of a worldwide credit crisis,
The Wall Street Journal ran a story about a
relatively obscure economist named Hyman Minsky.
Minksy, who died in 1996 at the age of 77, held
a theory about the way markets operate particularly
germane to individual investors.
Many economists believe that markets are essentially
“efficient” – namely that asset prices reflect
all available information. Minksy took a different
view. He believed, to quote The Journal’s story,
“that when times are good, investors take on
risk; the longer times stay good, the more risk
they take on, until they've taken on too much.”
The willingness to take risk can even lead to
a decision to borrow money to take on even more
(right, hedge fund guys?). Eventually, those
investors can’t make enough money on the realized
gains from their investments to pay for the
debt they took on to acquire them. Lenders tighten
up and call in their loans. The result, wrote
Minsky in his book, The Financial Instability
Hypothesis, is “a collapse of asset values."
Economists have coined such a phenomenon “a
Minsky moment.” When it’s really bad, they’ve
called it a “Minsky Meltdown.”
Whether the convulsions of both the stock and
the bond markets of late are a “moment” or a
“meltdown” is, of course, arguable. What isn’t
arguable is this: Investors clearly underpriced
risk. And if rational markets are about anything,
they’re all about assigning a proper value to
risk. That’s the whole principle behind a discount
rate. How much is a $1 sometime in the future
worth today? The discount rate is the barometer
that measures the risk of receiving that dollar
down the road.
How does one avoid being caught up in a Minsky
Moment? When I look back over our practice at
Wealth Enhancement Group, I can think of several
times when we were worried about such a phenomenon,
but also when we thought just the opposite was
true and the market was exacting too much of
a risk premium for an investment.
For example, for a time in 2002 and 2003, bond
“spreads” became unusually high. In other words,
bond investors had pushed corporate bond prices
relative to US Treasury securities to unusually
low levels. This was particularly true for below-investment-grade
bonds, popularly known as junk bonds. So many
investors bought junk bonds, reasoning that
the market had injected too much risk into that
sector of the market.
Since then, those spreads have narrowed substantially,
with investors “chasing yield” and bidding up
the prices of those bonds. Here, just the opposite
is true: Investors aren’t receiving enough reward
– in other words, a high enough yield on the
bonds, since bond prices and yield move in opposite
directions – for the risk they’re taking.
When the markets were rocked by the World Trade
Center tragedy, we encouraged our client not
to make any changes in their portfolios, but
throughout most of this period we’ve been avoiding
small capitalization growth stocks because of
a tendency of those stocks to move more on hot
air than sound fundamentals.
And when it comes to international stocks –
there’s hype there, too, we believe, but on
the opposite side of the ledger. We think the
risk in those stocks – we’re focusing here on
developed markets internationally, not emerging
markets – is overstated, and hence tend to encourage
our clients to look more closely at this asset
class.
What distinguishes all these views? Time. A
person’s time horizon is the great neutralizer.
The 9/11 headlines were tragic and grim, and
the markets reacted accordingly, but it was
important then, as now, to maintain a long-term
investment horizon. Similarly, as the markets
have shuddered under the worries wrought by
the problems in the U.S. housing market, how
will those problems look to us all five years
from now?
The headlines, we tell our clients, worry the
traders in these markets. The rest of us have
day jobs. In fact, when the traders are most
worried, true investors emerge.
Case in point: Who was out there buying US Bancorp
and other financial institutions right as the
housing crisis was blossoming?
Warren Buffett.
No Minsky moments for him.
The opinions voiced in this material are
for general information only and are not intended
to provide specific advice or recommendations
for any individual. To determine which investment(s)
may be appropriate for you, consult your financial
advisor prior to investing. All performance
referenced is historical and is no guarantee
of future results.
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