Saturday, October 4, 2008

Long History of the 2008 Financial Mess

Heather Whipps offers a very brief history of the banking system and our current Financial Mess in this article titled: "The Long History of the 2008 Financial Mess".

What is interesting is that the core of the 1929 collapse in the stock market and the 2008 collapse of the banking system both center on a belief that things will continue to rise at a rapid rate as they have in the recent past. In 1929, many believed that stocks would continue to rise rapidly, and in 2007 - 8, bankers and politicians believed that housing prices would continue to escalate. Compounding the problem is the use of highly leveraged financing to gamble on this false belief. In 1929, traders were gambling with borrowed money, and in 2008, bankers and politicians were gambling with highly leveraged or low down payment (low equity) loans to people who could not afford these loans.

This psychological fault can also be found among traders, including myself from time to time. It is easy to fall into the trap that prices will continue to go in the same direction as they have recently. You enter the market expecting a continuation of a direction, and then the market reverses turning expectations of a huge profit into a huge loss. The loss can be even larger with leveraged derivatives combined with a volatile market.

The one thing that traps us all in the beginning of a downfall is denial. We simply can not believe that the market is turning against us or that some economic model is proving false. We convince ourselves that the current situation is temporary, and that the situation will quickly turn to a falsely perceived normal condition. Even today, many on Wall Street and in Washington, D.C. can not believe that the mortgage model that worked so well during housing price escalation periods is no longer valid. Many traders take a long time, if ever, to include cycle periods into their trading plans.

Success in anything that involves finance and trading must include the belief and study of cycles. Very little if anything travels in a straight line. Even light waves and the rate of time are affected by gravity. Special mental attention should always be given to times when cycles are changing. This is the period when the greatest profit can be made, or the greatest loss can be avoided.

It is a wonder why the human brain spends so much energy trying to make things constant or linear when living in a universe where essentially nothing travels in a straight line, and everything is constantly changing.

Charles

No comments:

Post a Comment