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out five or 10 years, we™d like to live in a larger place. The current cost of
the house we expect to own is more than a million dollars.
I can make myself believe that we will make money in either a hous-
ing boom or bust. If prices rise, we make an additional capital gain on our
current property. If prices fall, our dream house will decline in price by
more than our current home. Thus, we will be able to upgrade to our
dream house for less than it would cost today.
So own some property, but expect to move up in the future.

Solution #2: Have a Fixed-Rate Mortgage

My advice on adjustable-rate mortgages is extreme. In As Good As It
Gets when Jack Nicholson™s neighbor (played by Greg Kinnear) swings
by for a visit, Nicholson launches into a tirade:

never, never again interrupt me. Okay? I mean, never. Not 30 years
from now . . . not if there™s fire. Not even if you hear a thud from
inside my home and a week later there™s a smell from in there that
can only come from a decaying body and you have to hold a hanky
against your face because the stench is so thick you think you™re
going to faint even then don™t come knocking . . . don™t knock . . .
not on this door. Not for anything. Got me. Sweetheart?

I paraphrase Nicholson to say, don™t get an adjustable-rate mortgage, not
even if you are sure you will move in one year, not even if the adjustable-
rate mortgage payment is much smaller than the payment for a fixed-rate
mortgage. Not for anything.
222 Applying Science and Art to Bonds, Stocks, and Real Estate

There are actually at least three good reasons to have an adjustable-
rate mortgage. First, real estate professionals may rationally want to take
a gamble in the area where they are experts. This applies to my nephew
Brent. If anyone is going to be able to get out at the top, it is likely to be
a professional like Brent with his finger on the pulse of the market.
Second, adjustable-rate mortgages can be perfect for someone who
knows she or he will sell soon. Consider, for example, a person who will
move in two years and who has an adjustable-rate mortgage that is fixed
for the next three years. For this person, an adjustable mortgage is almost
as safe as a fixed-rate mortgage. (Even in this situation, adjustable rates
are bit more risky because plans change and the fixed-rate mortgage pro-
vides more flexibility.)
Third, people who have lots of financial reserves can use adjustable-
rate mortgages. A central problem with an adjustable mortgage is that a
homeowner may be forced to sell into a down market. If the homeowner
has plenty of money stashed away for such a day, then there cannot be a
forced sale. So people who can afford fixed-rate mortgages can afford to
bet against the pros and not risk too much.
It is said that banks are willing to lend to anyone who doesn™t need the
money. Similarly, adjustable-rate mortgages provide lower payments but
should be used primarily by those who can most afford the higher pay-
ments of a fixed-rate mortgage.
So most, but not all, people should avoid adjustable-rate mortgages.
My advice on this subject is precisely the opposite of that of Federal
Reserve Chairman Alan Greenspan.19 In a speech on February 23, 2004,
Chairman Greenspan noted that in the decade prior to his speech, those
with adjustable-rate mortgages paid far less than those with fixed-rate
mortgages. He also pointed out that adjustable-rate mortgages are far
more common in some other countries. He concluded, the “traditional
fixed-rate mortgage may be an expensive method of financing a home.”
I disagree with the chairman for two reasons. First, I believe that inter-
est rates are likely to rise. Thus, when adjustable-rate mortgages come to
their adjustments, I expect payments to increase.
Second, an adjustable-rate mortgage is a bet on interest rates. If rates
Real Estate 223

increase by less than the market expects, you win with an adjustable
rate. If rates increase by more than the market expects, you lose. Thus,
those who choose adjustable-rate mortgages put their wealth at risk by
betting on interest rates. Furthermore, that bet is taken against profes-
My friend Greg used to bet against professionals of a different sort. He
loved poker and used to test himself by playing against card sharks in Las
Vegas. Because he was playing against pros, Greg expected to lose. He
judged his ability by how long he could stay in the game before going
broke. After one extremely successful evening, a pro took Greg aside and
said, “You™re an excellent young player, but when you have a strong
hand, your left jaw muscle tightens.” It was no surprise that Greg usually
lost against such competent adversaries.
Competing against poker professionals was a losing game for Greg.
Because he expected to lose, he never played for large stakes. He cer-
tainly would never have bet his house against professionals. Those who
take adjustable-rate mortgages are betting their houses (or at least a sub-
stantial chunk of their wealth) against professionals.
Adjustable-rate mortgages are tempting because the payments can be
so low. One day, while we were sitting in the Jacuzzi of our condo-
minium, my neighbor Alec told me that he was moving out of Cambridge
to a big house that he had purchased in the suburbs of Boston. As always,
I asked, “fixed or adjustable mortgage?” Alec responded “adjustable.”
When I asked why an adjustable-rate mortgage, Alec replied, “If we had
a fixed-rate mortgage, we couldn™t afford the purchase.”
I would recommend precisely the opposite strategy. If an adjustable-
rate mortgage is needed to make payments affordable, I suggest purchas-
ing a less expensive property.

Make Your Money at Work; Live in Your Home

Real estate has been the path to riches in America. Housing prices have
risen relentlessly for decades. Furthermore, the magic of leverage has
224 Applying Science and Art to Bonds, Stocks, and Real Estate

allowed people to make incredible rates of return. Millions of Americans
have made the bulk of their wealth through real estate.
Unfortunately, the easy money has been made. The housing market is
expensive and has a number of structural risks. The path ahead will be
less rosy than the path behind. If we are lucky we can still have an
expanding housing sector, albeit at a far more modest pace than in pre-
ceding decades. If we are unlucky, we may face persistently declining
housing prices for some time.
Accordingly, I suggest that people return to Peter™s advice regarding
housing. Buy a home that you plan to live in. Expect to make your money
in the area where you are an expert.
I also suggest putting yourself into a position where you can withstand
some housing market turmoil. Even if the more optimistic scenario
unfolds, it is likely that there will be some severe shocks to the system.
When such shocks occur, those with the strong financial hand will be in
a position to scoop up some values. Those with the weak financial hand
are likely to be shaken out of the market at the wrong time.
There is value in strength in many areas. I learned a variant of this les-
son when I was living in Uganda. I rode my motorcycle to Queen Eliza-
beth Park in western Uganda. In the park, I met with John, a man who
worked for the Jane Goodall Institute helping chimpanzees. When John
learned that I had ridden my motorcycle through the game park he
became quite concerned. “Are you good with the bike?” he asked. I
replied that I had just learned to ride. He looked concerned. He said,
“There are three types of animals to fear as you drive out of the park, and
I have specific advice for each type.”
“First, stand your ground against elephants. They are more likely to
give a mock charge than a real charge”of course be prepared to ride
away as fast as possible if the charge gets too close. Second, never stand
your ground against the buffalo. They never give mock charges, and it is
better to be trampled than gored.”
“Third, lions are the toughest.” John became concerned at this point”
“the trouble with lions is that by the time you see them it™s too late.” He
Real Estate 225

went on to say, “never ever back down from a lion. Once they sense fear
they are all over you. Furthermore, never turn your back on a lion”they
don™t like faces and when they eat people they tend to sit on the human™s
face. They pick on weak animals so when the road goes through thickets
where the lions hide, go fast and be loud, act like a strong and powerful
Act like a strong and powerful animal! I took John™s advice. Near
every thicket I accelerated and drove the motorcycle at top speed. I also
tried to keep the gear lower so that I could make more noise. I kept think-
ing, lions drag down the sick and old animals in the herd. Act like a pow-
erful animal, and they will leave me alone. On the drive, I saw an
elephant (I stood my ground and he walked away) and I outran a buffalo.
I did not see any lions; if they saw me from inside the thickets, apparently
they were impressed with my vigor.
My advice with housing is the same as John™s with lions. Be strong
and powerful. Make sure that you can withstand some tough economic
times. Those who can take the pain of a tough housing market put them-
selves in the position to profit from irrationality, not to become prey.
The Mean Markets and Lizard Brains advice with regard to housing is
to do the opposite of what has worked”have a fixed-rate mortgage and
own a smaller home than you plan to have in the future. Taking these
steps is very hard because it requires overriding the lizard brain. For
decades the best strategy has been to buy as much U.S. real estate as pos-
sible and ride the rocket ship to riches. Our backward-looking lizard
brain prods us to do what has worked in the past. In order to position our-
selves for trouble, however, we have to avoid the course of action that has
worked for generations. Those who can accomplish this psychologically
difficult task put themselves in a great position to profit.

from the
New Science
of Irrationality
228 Profiting from the New Science of Irrationality

his final section provides investment advice. In Chapter 10, we
learn more about the origins of the lizard brain and why it costs us
money. While our instincts may have helped our ancestors, we find
that financial markets are the most unnatural setting for our brains. An
understanding of the lizard brain provides a timeless blueprint for effec-
tive and low-stress investing.
In Chapter 11, we return to the central question of Mean Markets and
Lizard Brains: “Where should I invest my money?” In Part One we found
that we are built to have systematic problems in markets. In Part Two we
looked at macroeconomic drivers of financial performance. In Part Three
we examined the prospects for bonds, stocks, and real estate. Now in the
final section we summarize all of the findings. We discover that the cur-
rent situation is particularly dangerous”kryptonite for the lizard brain.
And then finally we come to a surprising answer to the question of where
to invest.
chapter ten

How to Shackle the Lizard Brain

Timeless and Timely Tips

In The Graduate, a young Dustin Hoffman (playing the role of Benjamin
Braddock) receives some succinct, and unsolicited, career advice from a
friend of his parents, Mr. McGuire:

“I just want to say one word to you . . . just one word.””McGuire
“Yes, sir.””Ben
“Are you listening?””McGuire
“Yes, sir. I am.””Ben

I don™t know if “plastics” was a good career choice in 1967 when The
Graduate was released. I am sure, however, that there are better and
worse times to work in particular fields. Similarly, the Mean Markets
view is that there are good times and bad times to make particular

230 Profiting from the New Science of Irrationality

investments. Gold, for example, was a great investment in the 1970s, and
was a terrible investment in the 1980s and 1990s.
If markets were rational, then investing would be easy and stress-free.
In the fairytale land of the efficient markets hypothesis, all investments
are correctly priced at all times. Thus, in a hypothetical, rational invest-
ing world, it never pays to fret about possible mistakes; nor does it pay to
seek bargains.
Out in the real world, however, markets are irrational and often
mean. This creates both opportunity and risk. In a world where prices
are often too low or too high, investors can find insanely good deals.
We can also make insanely bad deals. Since the invisible hand has not
built a world that is going to ensure our financial success, we have to do
it ourselves.
Thus, the key to investing success”in the real world”is to be on the
correct side of that irrationality. The Mean Markets and Lizard Brains
advice for how to profit from manias and crashes is divided into two
parts. First we™ll seek to prevent our own lizard brain from ruining us
(this chapter). Then we™ll look for opportunities to make money from
others™ lizard brains (next chapter).
This division of tips for investing in crazy markets is somewhat akin to
preparing for a sports competition. To win, it is always good to be strong,
fast, and experienced. The best strategy on any given day, however, also
depends on the competition.
In the late 1980s, for example, the Detroit Pistons won consecutive
NBA championships. In each championship year, they had to defeat
Michael Jordan™s Chicago Bulls in the playoffs. To beat the Bulls, the
Pistons relied upon excellent basketball skills (appropriate for any oppo-
nent), and they needed a specific strategy to contain Jordan. In this period
of his career, Jordan was so dominant that opponents joked, “He can™t be
stopped, just contained.”
To contain Jordan enough to win, the Pistons developed what became
known as the “Jordan Rules.” These included myriad defensive schemes,
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