One More Note on Failure

Recently, we had a problem at the Merkel house: a toilet overflowed and the water did not shut off, flooding the room, and leaked into the basement.  Why did this happen?  Two things went wrong at the same time:

  1. The toilet needed to be plunged, because there was a blockage preventing water discharge, and
  2. The flapper malfunctioned, and so water continued to flow.

If only one of these problems had happened, we would have had an ordinary problem.  I can plunge a toilet, easy.  I can hear the toilet singing, and know that the flapper is up, jiggle the handle, and end the problem.

Most of the time, when we plan against failure, we look at solutions that address single failures.  We do not contemplate two things going wrong at once.

Yet, when we look at big failures in investment, there are often two things that went wrong at the same time.  Usually it follows a pattern like this:

  1. Take a risk that in ordinary times often works out, but
  2. You don’t get that times are not ordinary, and so the odds are actually stacked against you.

I have several examples for this.  Taking on debt to buy a house was a wonderful strategy until overall debt levels to finance housing got to high, but at that time, the momentum effect of rising house prices was sucking people into buying houses, because they thought it was easy money.

Financial stocks were the market leaders for many years up through 2007, as investors assumed that ordinary risk control would protect the banking system.  But what happens when debt levels are too high, so that many debts are incapable of being paid?

As Warren Buffett has said (something like), “We get paid to think about the things that can’t happen.”  Multiple failures leading to large bad results are worth thinking about.  So what aren’t we thinking about now?

  • Failures in retirement security systems as the Baby Boomers age.
  • Failures in government debt as overleveraged governments can’t make debt payments.
  • Inflation rises rapidly as the economy revives amid increased lending from banks.
  • Deflation persists as the central bank tries to force-feed credit to an already overleveraged economy.

(There are many patting themselves on the back thinking that the Central Banks and Governments got us out of a crisis, when they only delayed the crisis.  High nominal debt levels relative to GDP create their own crisis.)

I would encourage you to think about your investments, and ask the following questions:

  • Are there hidden factors that could lead to a big failure?  (Think of what happened to mortgage REITs in 2008 when the repo market crashed.)
  • How well would the investment fare if inflation went up significantly?
  • How well would the investment fare if real interest rates went up significantly?
  • How well would the investment fare if we hit another patch where financing is not available?  Can the investment self-fund?
  • How much future prosperity does the current price of the investment embed in its valuation?

I know, glum words.  But this might be a good time to look at what you own, and ask how survivable it is under stressed conditions.

All for now.

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