The twist was that the football player had to push right next to the
hinges, while the skinny kid got to push on the edge farthest from the
hinge. The scrawny boy won easily! The reason was leverage; being far-
ther from the hinge provided an enormous advantage.
Housing has been the road to riches for two reasons. First, U.S. hous-
ing prices have been rising relentlessly since World War II. Second,
because people are able to buy houses with relatively small down pay-
ments they can have tremendous leverage.
Recall Fatima Meloā™s home purchase that we discussed earlier. The
young couple bought a house for $95,000, which they sold for $358,000.
So they bought a house that increased in value by 277%. So how much
did they earn on their investment? They invested $5,000 and borrowed
$90,000. After selling the house and paying off the mortgage this $5,000
had swelled to $268,000! Now thatā™s leverage! Figure 9.7 shows the
return on this investment in reality (with leverage) and how it would have
performed without leverage.
Financial leverage is great in bull markets. To make the most money
the rule is simple: The lower the down payment, the greater the return on
1000% 277% 277%
% home price % return without Actual % return
increase leverage (with leverage)
FIGURE 9.7 Leverage Boosts Returns in a Rising Market
Real Estate 215
investment. Alternatively, for any fixed down payment, the bigger the
house, the more profits. The road to riches in the U.S. housing market has
been to buy as much property as possible and borrow as much as possi-
ble to leverage profits. It has truly been an astounding way to make
There are two risks to leverage. One is individual, and the second is
the spillover effect on others.
Groucho Marx learned the individual consequences of leverage in the
1929 stock market crash.11 Groucho was opposed to gambling but had
nevertheless invested his life savings into stocks. And he bought stocks
on margin. In the 1920s the customary margin requirement was 10%.
This allowed a speculator (or investor) to buy $1,000 worth of stock with
$100 of cash. A 10% margin requirement allows for 10 to 1 leverage.
What are the effects of buying stocks on margin? With maximum
leverage, any movement in the stock is magnified 10-fold. So a 1% rise
in stock would produce a 10% return on investment. Throughout the bub-
bly 1920s people focused on the ability of leverage to increase returns.
Groucho found out that leverage works to dramatically decrease
returns in a down market. A 1% decline in a fully margined account leads
to a 10% loss on investment. More important, a mere 10% decline leads
to total wipeoutā”a 100% loss.
As Grouchoā™s stocks declined in 1929 he did what he could to avoid
selling into a dropping market. He put up additional cash, and he bor-
rowed money to provide margin for his stocks. In the end, he lost every
Leverage was financial disaster for Groucho Marx (fortunately for
him, he was able to recover through making successful movies after he
went bankrupt). Grouchoā™s decision to margin stocks also hurt other
investors. At the market top, Marx owned a lot of stock. Once he was
bankrupted he owned noneā”he was forced to liquidate his holdings as
the market declined.
In a leveraged market, price declines put owners in financial distress
as they are forced to liquidate. The liquidation puts further selling pres-
216 Applying Science and Art to Bonds, Stocks, and Real Estate
sure on prices, and the further declines then cause more financial distress
and more forced selling.
Margin calls were widely attributed as a major cause of the 1929
crash. The Securities Exchange Act of 1934 was enacted to curb the
excesses of the 1920s. Section 7 of the Act addresses margin lending,
For the purpose of preventing the excessive use of credit for the pur-
chase or carrying of securities, the Board of Governors of the Fed-
eral Reserve System shall . . . prescribe rules and regulations with
respect to the amount of credit that may be initially extended and
subsequently maintained on any security.12
Under this law, the Federal Reserve sets stock margin rates. They have
maintained the required level at 50% for several decades.
A dollar today can buy two dollarsā™ worth of stock. The same dollar
can buy many, many dollars of real estate. It is relatively easy to borrow
$20 for every $1 of down payment. Furthermore there are a large number
of ways to avoid putting any money down to buy real estate (and these go
far beyond āno money downā techniques so common on infomercials).
Small down payments create massive leverage. The greater the leverage,
the greater the possible gainsā”and possible losses.
Mortgage debt is now at all-time highs, and home equity as a percent-
age of home values is at an all-time low.13 Investors are increasing their
leverage.14 Presumably, they hope to hit a home run like Fatimaā™s. The
negative potential, however, is that leverage in the real estate market will
lead not to riches but to an outcome more like Grouchoā™s.
Risk #3: Adjustable Rate Mortgages
My nephew Brent attended the University of Montana and immediately
after graduation began work as a real estate agent in his hometown of
Ann Arbor. Early in his career he had a great chance to buy some bargain
Real Estate 217
A development project created a number of condominiums. A city
ordinance required that some of the units be sold at cut-rate prices to low-
income people. Business is generally slow for new real estate agents so,
freshly minted Brent met the low-income guidelines. He was able to buy
a condominium for about $20,000 below market price (the law prevents
him from reselling for two years).
When it came to financing, Brent wanted a mortgage with the lowest
monthly payment. Accordingly, he picked an adjustable-rate mortgage
(ARM). After three years, Brentā™s interest rate will change. Brentā™s ARM
produces a low payment. It also produces risk for my nephew. With inter-
est rates near both theoretical and historical lows, those who have ARMs
face the risk that their payments may rise substantially.
I asked Brent if he feared rising interest, and he replied by saying āif
my mortgage interest rate is adjusted upwards, Iā™ll just sell my condo.ā
Sound reasonable? It may, but it is not for the same reason that the Dow
Jones Industrial Average lost 500 points in one day in 1987. The problem
with Brentā™s strategy is that heā™s not the only one with that strategy. Many
people with ARMs may think they will sell prior to big mortgage pay-
ment increases, which is the functional equivalent of an elephant stam-
pede trying to get through a small door openingā”all at the same time.
To understand this risk it is necessary to understand the systematic
effects of everyoneā™s strategy. Sometimes it pays to do the same thing as
everyone else. In the United States, for example, it is obviously good to
drive on the right side of the road. Similarly, it is easier to swap word
processor files around if we all use the same programs (nowadays that
program is Microsoft Word). As we have learned, however, finance is a
game where it often pays to avoid the herd.
The 1987 stock market crash was made more severe by the common
use of portfolio insurance. The stock market was soaring in the early part
of 1987, and people wanted to get rich. Some people were also worried
that stock prices were too high. They could have reduced risk by selling
some of their stocks, or by a whole host of financial strategies such as
selling short or buying puts. The trouble with all of these techniques for
218 Applying Science and Art to Bonds, Stocks, and Real Estate
reducing risk is that they also reduce the gains. What was a greedy but
scared investor to do?
So-called āportfolio insuranceā provided the answer. With it, the buyer
could enjoy all the benefits of owning stock and also be protected against
lossesā”or so the argument claimed. Hereā™s how portfolio insurance
worked. Stuff the portfolio with stocks. This provides the fuel for fat
returns if stocks rise. The āinsuranceā on the portfolio was a plan to sell
stocks if they declined. As stocks would sink, the investor would rapidly
shift out of stocks and into safe bonds.
In theory, portfolio insurance had all the benefits of stock ownership
without the risk. If stocks began to decline the investor would magically
be shifted out of stocks. This seemed like such a great idea that firms sold
this insurance and many investors bought it.
What happened to those who bought portfolio insurance? They got
massacred in the 1987 stock market crash.15 And they almost destroyed
everyone else, too. In the second half of 1987, the stock market began to
decline. As stocks declined, those who owned portfolio insurance sold
stocks, which in turn caused prices to fall further. This selling culminated
in the Dow Jones Industrial Average losing over 20% of its value in one
day. The decline in the 1987 crash in percentage terms was almost twice
as large as the 1929 crash.16
Investorsā™ portfolios turned out not to be protected from the 1987 crash.
The theoretical analysis of portfolio insurance assumed that markets would
move gradually. In the real world, prices did not move gradually, but rather
took huge steps down. Investors who thought they would exit stocks after
small declines found themselves selling at precisely the wrong time.
If only one person had used portfolio insurance it might have worked
fine. Because the strategy was common, however, the system built upon
itself to create a selling frenzy. Those with portfolio insurance made the
worst mistake possible in mean markets; they bought at the top, and put
themselves in a position where they had to sell at the bottom.
Similarly, if Brent were the only person with a āsell if rates riseā
Real Estate 219
strategy, it might work fine. However the truth is exactly the opposite.
One-third of new mortgages are adjustable-rate mortgages, which is near
an all-time high.17 The prevalence of adjustable-rate mortgages makes
the āsell my place if interest rates riseā strategy risky. If interest rates
continue to rise, then millions of homeowners will be looking to sell
when their mortgages adjust. This is unlikely to be a profitable time to be
When bad things happen they often appear unavoidable. In reality,
however, the required steps to avoid ruin need to be taken much earlier.
This is something that investors need to know, and also something that
would have helped a man named Robert Brecheen.
At around 9 p.m. on August 10, 1995, Robert Brecheen tried to com-
mit suicide by overdosing on pain pills. Mr. Brecheen was rushed to the
hospital and revived by the administration of powerful drugs. At 1:55 on
August 11, just five hours later, Mr. Brecheen was executed by lethal
injection in the Oklahoma State Penitentiary.18
Mr. Brecheen was sentenced to death for committing murder in the
first degree. After years on death row, all of his appeals had been denied
and his execution loomed. Rather than let the state kill him, Mr. Brecheen
decided that he would control the time and manner of his own death by
committing suicide. Even in this, he failed. Mr. Brecheen got into a situ-
ation where he had zero control over his life. He was not able to even
decide how or when to die.
Investors who are on the wrong side of mean markets face outcomes
that are far less severe than execution but similarly inflexible. Those who
buy at that top are often forced to sell at the bottom. A key to making
money in mean markets is to retain control of the time of oneā™s buying
Adjustable-rate mortgages remove control of when to sell a home.
Those with adjustable-rate mortgages may be pressured to sell their
properties at the same time as others. Thus, those who seek to profit from
market craziness should avoid adjustable-rate mortgages.
220 Applying Science and Art to Bonds, Stocks, and Real Estate
Solution #1: Plan to Buy a Larger Home
in the Future
The Mean Markets and Lizard Brains advice is to own some real estate
but expect to move to a more expensive property in the future. If housing
prices were a bubble, the correct strategy would be to own nothing and
rent. Because housing prices are high, but not in a bubble, the suggestion
is to own something less than your dream house. This strategy can be
profitable regardless of whether housing prices fall or rise. How can this
strategy win in all environments? Hereā™s how a similar strategy worked
in the stock market.
Near the top of the technology stock bubble, I found out that my older
sister Sue had invested most of her retirement account in an aggressive
technology mutual fund. I suggested that this was a very bad idea and
that she sell. Some weeks after she agreed to sell her overvalued tech
stocks, I asked if sister Sue had made the phone call to change her invest-
ment. āNo,ā she said, ā I havenā™t, I donā™t want to miss the rally.ā
To solve the problem we came up with the following strategy. Sister Sue
sold one-quarter of her stocks. Now, I said, if stocks go up you will make a
ton of money as you still have hundreds of thousands of dollars invested. If,
however, stocks decline youā™ll have saved a lot of money by selling.
Technology stocks did decline, and Sue asked if she should buy back
the stock. I said, no, now sell another quarter. If stocks rally, you will
make money. If they fall, you will have saved more money. We continued
this process until she completely exited her technology stocks. In the end
she exited pretty close to the NASDAQ top of 5,000 and actually made
money on her tech stock investments.
How can a decision to sell be good in both up and down markets? The
answer is that it is a psychological trick. Obviously, the decision to sell
stocks reduces profits if stocks rise afterwards. In the case of a stock mar-
ket rally, I suggested that sister Sue savor the profits on the stocks she still
owned, not the profits she hadnā™t earned on the stocks that she had just sold.
The win-win framing of selling stocks is a form of irrationality. Nev-
ertheless, such tricks can help us precisely because we are not completely
Real Estate 221
rational decision makers. Our financial plans are often hurt by our irra-
tionality; it is great to use irrationality to our advantage.
Owning a relatively small house also allows for a win-win outcome
with the appropriate psychological framing. As always, I follow my own
advice. My wife and I live in a Cambridge condominium worth a bit
more than $600,000. We hope to have more children, and when we look