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The recent housing bubble that gave way to a credit crunch and banking crisis in the United States and Europe is neither an isolated economic event nor a phenomenon that for which a single individual or handful of individuals can be held accountable. The rise of asset bubbles—stocks, commodities, or real estate—results from a confluence of human nature, innovation, and easy credit. Even as the specific attributes of various bubbles tend to differ, the pattern of events in which bubbles rise and then collapse is a familiar one. Recognition and understanding of those realities offers perhaps the most secure foundation for financial risk management.
In the opening of Benjamin Graham's classic work Security Analysis, Graham wrote of the 1927-33 period that witnessed the U.S. stock market crash and, in its aftermath, the Great Depression:
It can hardly be said that the past six years have taught us anything about speculation that was not known before. Even though the last bull and bear markets have been unexampled in recent history as regards both magnitude and duration, at bottom the experience of speculators was no different from that in all previous market cycles… That enormous profits should have turned into still more colossal losses, that new theories should have been developed and later discredited, that unlimited optimism should have been succeeded by the deepest despair are all in strict accord with age-old tradition.
Graham’s findings also revealed that although markets can be reasonably efficient and rational, there are limits to their efficiency and rationality. The regular swelling and bursting of asset bubbles provides illustrates such limits. The periodic oscillation between the euphoria during which bubbles swell and panic that ensues following their collapse highlights the excess to which markets can swing.
Some excerpts from Mr. Graham’s seminal book are as relevant to today's economic and financial challenges as they were to the Great Depression era:
• "Investment is by nature not an exact science."
In other words, given this reality, the idea that financial engineering could yield precise mathematical models that would all but eliminate risk and/or ensure attractive returns on investment is little more than sheer folly. The breakdown in quantitative models, even the widely employed Value at Risk (VaR) models, during periods of market stress such as the present period is to be expected. Models are mere representations. They are simplifications of highly complex phenomena.
• Market fluctuations "have a strong psychological, if not financial, effect" on investors.
Market psychology can trump market fundamentals, both when prices are rising and when they are falling. If fundamentals alone guided market performance, one would not witness, among other things, the development of asset bubbles or price busts during which prices fell far below levels justified by economic fundamentals.
• "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants."
One should not expect that investments would quickly revert to prices consistent with fundamentals. Even as fundamentals play a leading role in the long-term, prices can diverge from fundamentals for an extended period of time.
• "[ I ]n 1928 and 1929 there occurred a wholesale and disastrous relaxation of the standards of safety previously observed by the reputable houses of issue [investment banks]. This was shown in the sale of many new offerings of inferior grade, aided in part by questionable methods of presenting the facts to the public... This general lowering of standards by investment banking firms was due to two causes, the first being the ease with which all issues could be sold, and the second being the scarcity of sound investments to sell."
One witnessed similar behavior in lending, investing, and borrowing standards associated with the purchase of homes in the run-up of the housing bubble. One saw accounting standards deteriorate with relied use of off-balance sheet vehicles, the use of quantitative models to provide asset valuations, and the opacity associated with the proliferation of derivative instruments. Public policy officials expressed no concern even as U.S. mortgage debt rose from about 61.5% of GDP in 1995 toward and then above 100% of GDP in the mid-2000s. While the originate-to-distribute model and mortgage securitization helped the housing market function more effectively, once lending, borrowing, and investing standards crumbled as happens in the run-up of all asset bubbles, those tools disseminated the seeds of contagion on a global basis, helping assure that when the housing bubble finally collapsed that it would have global implications.
• "...the margin trader...swims with the tide, hoping to gauge the exact moment when the tide will turn and to reverse his stroke the moment before. In this he rarely succeeds, so that his typical experience is temporary success ending in complete disaster."
In other words, those who live and prosper by leverage, die by leverage when market conditions change rapidly. Given that the timing of turning points is so difficult, overleverage can be excessively risky. The growing number of deceased hedge funds, along with investment banks such as Bear Stearns and Lehman Brothers, in the wake of the collapse of the U.S. housing bubble, provides a vivid monument to the dangers of excessive leverage.
• "…if past experience is any guide, the current critical attitude of the investor is not likely to persist; and in the next period of prosperity and plethora of funds for security purchases, the public will once again exhibit its ingrained tendency to forgive, and particularly to forget, the sins committed against it in the past."
The experience Graham describes is a regular feature of human nature. Lessons of the past, standards of risk management, and investor caution all erode during booms. Instead, euphoria pushes borrowers, lenders, and investors to push the frontiers of risk in an aggressive pursuit of the last dollar of marginal profits. In such a rush, the scramble for market share trumps prudence. In such an environment, easy credit and the herdlike rush for marginal profits can feed the rise of an asset bubble. Over time, such a bubble can burst with destructive economic consequences.
In sum, the lessons of the past provide a potentially invaluable foundation for risk management. In the wake of the most recent crisis associated with an asset bubble that collapsed beginning during summer of 2006, such lessons have again become timely. However, if the risk of future asset bubbles is to be mitigated, it will be important that timeless works such as Graham’s be incorporated into business school curricula and professional education in the field of finance. Otherwise, as Graham predicts, the human “tendency to forgive, and particularly to forget, the sins committed against it in the past” will lead to society’s being caught unprepared when a new asset bubble rises and then bursts in the future.
In the opening of Benjamin Graham's classic work Security Analysis, Graham wrote of the 1927-33 period that witnessed the U.S. stock market crash and, in its aftermath, the Great Depression:
It can hardly be said that the past six years have taught us anything about speculation that was not known before. Even though the last bull and bear markets have been unexampled in recent history as regards both magnitude and duration, at bottom the experience of speculators was no different from that in all previous market cycles… That enormous profits should have turned into still more colossal losses, that new theories should have been developed and later discredited, that unlimited optimism should have been succeeded by the deepest despair are all in strict accord with age-old tradition.
Graham’s findings also revealed that although markets can be reasonably efficient and rational, there are limits to their efficiency and rationality. The regular swelling and bursting of asset bubbles provides illustrates such limits. The periodic oscillation between the euphoria during which bubbles swell and panic that ensues following their collapse highlights the excess to which markets can swing.
Some excerpts from Mr. Graham’s seminal book are as relevant to today's economic and financial challenges as they were to the Great Depression era:
• "Investment is by nature not an exact science."
In other words, given this reality, the idea that financial engineering could yield precise mathematical models that would all but eliminate risk and/or ensure attractive returns on investment is little more than sheer folly. The breakdown in quantitative models, even the widely employed Value at Risk (VaR) models, during periods of market stress such as the present period is to be expected. Models are mere representations. They are simplifications of highly complex phenomena.
• Market fluctuations "have a strong psychological, if not financial, effect" on investors.
Market psychology can trump market fundamentals, both when prices are rising and when they are falling. If fundamentals alone guided market performance, one would not witness, among other things, the development of asset bubbles or price busts during which prices fell far below levels justified by economic fundamentals.
• "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants."
One should not expect that investments would quickly revert to prices consistent with fundamentals. Even as fundamentals play a leading role in the long-term, prices can diverge from fundamentals for an extended period of time.
• "[ I ]n 1928 and 1929 there occurred a wholesale and disastrous relaxation of the standards of safety previously observed by the reputable houses of issue [investment banks]. This was shown in the sale of many new offerings of inferior grade, aided in part by questionable methods of presenting the facts to the public... This general lowering of standards by investment banking firms was due to two causes, the first being the ease with which all issues could be sold, and the second being the scarcity of sound investments to sell."
One witnessed similar behavior in lending, investing, and borrowing standards associated with the purchase of homes in the run-up of the housing bubble. One saw accounting standards deteriorate with relied use of off-balance sheet vehicles, the use of quantitative models to provide asset valuations, and the opacity associated with the proliferation of derivative instruments. Public policy officials expressed no concern even as U.S. mortgage debt rose from about 61.5% of GDP in 1995 toward and then above 100% of GDP in the mid-2000s. While the originate-to-distribute model and mortgage securitization helped the housing market function more effectively, once lending, borrowing, and investing standards crumbled as happens in the run-up of all asset bubbles, those tools disseminated the seeds of contagion on a global basis, helping assure that when the housing bubble finally collapsed that it would have global implications.
• "...the margin trader...swims with the tide, hoping to gauge the exact moment when the tide will turn and to reverse his stroke the moment before. In this he rarely succeeds, so that his typical experience is temporary success ending in complete disaster."
In other words, those who live and prosper by leverage, die by leverage when market conditions change rapidly. Given that the timing of turning points is so difficult, overleverage can be excessively risky. The growing number of deceased hedge funds, along with investment banks such as Bear Stearns and Lehman Brothers, in the wake of the collapse of the U.S. housing bubble, provides a vivid monument to the dangers of excessive leverage.
• "…if past experience is any guide, the current critical attitude of the investor is not likely to persist; and in the next period of prosperity and plethora of funds for security purchases, the public will once again exhibit its ingrained tendency to forgive, and particularly to forget, the sins committed against it in the past."
The experience Graham describes is a regular feature of human nature. Lessons of the past, standards of risk management, and investor caution all erode during booms. Instead, euphoria pushes borrowers, lenders, and investors to push the frontiers of risk in an aggressive pursuit of the last dollar of marginal profits. In such a rush, the scramble for market share trumps prudence. In such an environment, easy credit and the herdlike rush for marginal profits can feed the rise of an asset bubble. Over time, such a bubble can burst with destructive economic consequences.
In sum, the lessons of the past provide a potentially invaluable foundation for risk management. In the wake of the most recent crisis associated with an asset bubble that collapsed beginning during summer of 2006, such lessons have again become timely. However, if the risk of future asset bubbles is to be mitigated, it will be important that timeless works such as Graham’s be incorporated into business school curricula and professional education in the field of finance. Otherwise, as Graham predicts, the human “tendency to forgive, and particularly to forget, the sins committed against it in the past” will lead to society’s being caught unprepared when a new asset bubble rises and then bursts in the future.
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