Why bubbles matter to even a cautious investor?

The creation and bursting of bubbles can have direct or indirect impact on the finances of even a very cautious investor.

If the investor is aggressive and has invested borrowed money during a bubble, the results could be disastrous. However, even for a conservative investor, there could be major impact if a large number of big investors have invested borrowed money. Such a situation can lead to severe economic consequences in the aftermath of the bursting of the bubble.

Less than a decade ago, we witnessed such an event, popularly known as the sub-prime crisis. Large banks, institutions, hedge funds and even some Sovereign funds borrowed heavily and invested the money in risky assets. The after effects were felt across the world and by all investors – aggressive or conservative.

I have written the following in the beginning of the Chapter 2.9 – The Sub-prime Crisis:

In early 2014, while referring to the global meltdown of 2008-09, an IFA asked, “How does one explain to a school teacher in rural India that her portfolio value dropped by around 50% because someone on the other side of the world defaulted on his housing loan?”

Think about it. The investor thought that she was conservative and taking least risk. What she did not know was that it was someone else’s action that impacted her.

Read and learn from history. It is a good protection against the stupidity of others and of your own.

#RidingTheRollercoaster – 217

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Bond markets and maturity

There is a popular joke about the bond markets:

“What is the difference between bonds and bond traders? Well, bonds have maturity”

Look at the history of financial markets and you will realise that at the root of most of the crises, leverage was involved. People borrowed too much and invested the proceeds in a risky investment that did not appear to be too risky then. Risk was not absent, it was just not visible for various reasons. One of the most significant reasons behind this invisibility of risk had nothing to do with the risk, it had everything to do with the eyes of the person involved – the sight was clouded by greed.

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Ignorance, illiquidity and leverage

When you combine ignorance, illiquidity and leverage (or borrowed money), it can create havoc.

Very often, the ignorance is about liquidity and sometimes about leverage. Ignorance may lead to making rash decisions.

Remember the story of Abhimanyu in chakravyuh? (You can read the story here Abhimanyu in Chakravyuh)

#RidingTheRollerCoaster – 70

Beware of leverage

Recently, I read an interview of Mr Rajeev Thakkar, CIO of PPFAS Mutual fund in the Value Research magazine. Somewhere in the interview he mentioned, “… leverage in the wrong hands can be devastating.”

During the great depression, a young investment professional  – Benjamin Graham – used too much leverage. This was a combination of leverage and a crash in the market. His portfolio hugely underperformed the overall market.

Graham corrected his mistake subsequently and emerged a winner. Graham eventually came to be known as the “Father of investing”. One of his disciples, Warren Buffett, earned more fame than the teacher.

After his disastrous experience as an investor during the great depression, Graham said that the mistake was that he owed money. “I didn’t repeat that after that.“, He said.

Leverage is not bad by itself, too much of it is disastrous.

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