One of the most important ideas to be developed by a chess player was Steinitz’s principle of proportion. The former World Champion and father or modern chess strategy stated that the attack must be in proportion to the amount of advantage held, a concept which has far reaching applicability in other spheres.
The area which most readily comes to mind is that of speculation, many traders failing not because they were right or wrong but simply through having overplayed their hand with excessive leverage. One can be quite right on overall direction, but excessive leverage means that you can be forced out of a position before it finally goes in the direction that has been predicted.
It could well be that this is a major factor in ‘the public’ losing money in stocks as well. The cause of public selling is commonly attributed to the fear caused by falling prices, but perhaps there’s a heavy leverage element in there as well. During the good times people will often have a surplus and will think about saving for the future in a rising asset class. But when a downturn arrives increasing pressure on the necessities of life (induced perhaps by a drop in income) forces them to sell these investments.
Where Steinitz’s theory really kicks in is when someone is heavily leveraged in investments such as housing, their ‘attack’ being way out of proportion to the perceived advantage (rising prices). When the denouement comes their position can deteriorate at a horrifying rate, for example being a modest 3 times leveraged (owning £50k of a £150k house) means that a 15% adverse move in housing causes a 45% loss in net worth.
Obviously this is much worse in the case of a ‘buy to letter’ who has several properties based on a 5% deposit. Even if they’re tenanted they will be losing money as long as the mortgage is higher than the rental yield. The situation may not be too bad as long as they can support the cash bleed with their salary and the properties are fully occupied. But take one of these supports away and the position can rapidly implode.
This is why I’d make ‘Lasker’s Manual of Chess’, which explains these things, compulsory reading at schools throughout the land. Any openings in the ministry of education?
Nigel,
A friend of mine was trying to get me to invest with him in the real estate bubble. I saw the bubble, my late lovely wife saw the bubble, and even my kid saw it when we were offered a mid seven figure sum for our little beachfront shack for a teardown. I declined to act on my friends compelling argument and only trade what I know. since he’s just a real estate investor, he’s been buying nice, single family homes all the way to the top. Now, he’s stuck with 36 properties, 36 mortgages, 36 mortgage payments, and 20 tenants who tend to call him at three in the morning to fix a toilet.. He’s being bled dry, and has been reduced to sending his wife to work as a teacher to pay the household bills. However, he steadfastly refuses to bail out of the properties, clinging with slim hope that the market will come roaring back. Poor guy is acting very delusional as of late and always insists on buying then rounds at our favorite restaurant/bar, Pelican Alley.
Speaking of Pelican Alley, If you’re ever in this time zone, I’ll buy you lunch there. It has a great chef, and the food and atmosphere is excellent.
Jeff
By: masteroftheuniverse on November 14, 2008
at 3:16 am
Jeff,
The worst thing with buying houses seems to be that it’s so difficult to get out of it, so your friend may be a bit stuck. Maybe his best bet now is to try to hang on for a decade or so and get more of those mortgages paid off. The other main hope might be really low interest rates, but if we get a deep recession will he still have full occupancy? Not so long back several families would share a house, and you can still find this in many countries.
Of course the way round the liquidity issue is to invest in REITs, but that isn’t enough for most people because they don’t get the ‘magic’ of leverage. It amazes me that the banks seemed happy to lend on actual bricks but they’d have laughed in my face if I’d have asked for 20 times my outlay to buy into a REIT.
It might be a while before I get over to the US again but if and when it happens I’ll take you up on that. Thanks.
Nigel
By: ndavies64 on November 14, 2008
at 7:12 am