The two big ones

Dear Gala,

I want the first of these letters to be about the hardest thing the market will ever do to you, because if you understand this one, most of the others take care of themselves.

Twice in the last hundred years the financial world came close to ending. Not a bad year, not a correction. The kind of collapse where serious people wondered whether the system would still exist in the spring. I want to tell you about both, what they had in common, the one thing that made them different, and who to read when it happens again. Because it will.

1929

In the summer of 1929 you could buy shares in America with ten percent down. The broker lent you the rest. Everyone was doing it, and everyone was getting rich, and the men who ran the country said the economy was on a permanently high plateau. The market peaked in September. By the summer of 1932 it had fallen eighty-nine percent. Not a typo. A dollar became eleven cents.

The people who had borrowed to buy were gone in the first weeks. Their brokers sold them out the moment prices dipped, which pushed prices lower, which sold out the next group. Then the banks started failing, thousands of them, and there was no insurance on deposits, so families who had never bought a share in their lives lost their savings anyway. A quarter of the country was out of work. It took twenty-five years for the market to get back to where it had been that September.

2008

Seventy-nine years later it was houses instead of shares, but the shape was the same. You could buy a house with nothing down. The banks that lent the money had borrowed thirty dollars for every one they owned. Everyone was doing it, and everyone was getting rich, and the people in charge said house prices did not fall nationally. In September 2008 a bank called Lehman Brothers, one of the oldest in the world, went bankrupt over a weekend, and for a few weeks nobody knew who would be next. The market fell fifty-seven percent from top to bottom. It took about five years to get back.

I was there for that one. I had just finished university and was looking for my first real job, and I remember the strange feeling of stepping out into the world at the exact moment the world seemed to be coming apart. The news every morning was worse than the night before. Companies that had been hiring in June were gone by November. I learned two things that year that I have never had to unlearn. The first is that it passes. I want you to read that one slowly, because it is the most important sentence in this letter. It always passes, even when every voice around you is certain that this time it will not. That is true of markets, and it is true of businesses, and it is true of the worst things that will happen to you in life. Nothing I have seen since has contradicted it. The second is that the most valuable thing I owned during those months was not money. I had some, not a lot, and it was not what got me through. What got me through was a cool head. That turned out to be the only hedge that has never failed me since.

What they had in common

Strip away the details and the two crises are the same story. Something real and good, the stock market in the twenties, the housing market in the two-thousands, attracts money. The money is cheap, so people borrow to buy more. Prices rise, which proves everyone right, which attracts more borrowing. Then something ordinary happens, a rate goes up, a bank has a bad quarter, and the people who borrowed have to sell. Their selling forces the next people to sell. A market can fall thirty percent on its own. It takes borrowed money to turn that fall into a panic, because a person who owns something outright can wait, and a person who owes money on it cannot.

Two men described this better than anyone. Charles Kindleberger wrote a book called Manias, Panics, and Crashes that walks through four hundred years of these episodes and shows they all have the same five stages, and that credit is the fuel in every one. Hyman Minsky explained why: long periods of calm make people comfortable with more debt, so the calm itself creates the conditions for the fall. Stability breeds instability. When you hear someone say that a crisis came out of nowhere, they have not read either of them.

The one thing that was different

Here is why 1929 became a decade of misery and 2008 became a terrible year and a half. In 1963 Milton Friedman and Anna Schwartz published a history of money in America and showed that the Depression was not the crash. It was what came after. The central bank sat on its hands while a third of the money in the country simply disappeared with the failing banks, and that is what turned a fall into a collapse.

One of the people who read that book was a young economist named Ben Bernanke, and it changed his life. He spent the next thirty years studying the Depression and asking one question: what should the central bank have done in 1930? In 2002, at a party for Friedman’s ninetieth birthday, Bernanke, by then a senior official at the Federal Reserve, stood up and apologized in public. The Fed had caused the Depression, he said, and it would never let it happen again.

Six years later he was in charge of the Federal Reserve when the crisis of 2008 hit, and he did what he had promised. When Lehman Brothers, a bank the size of a small country, went bankrupt in a single weekend, the Fed and the government stepped in and flooded the system with money so the other banks would not fall too. It was ugly, it was unfair, and a lot of people who deserved to be punished were rescued. But it worked. The banks stayed open, the money did not vanish, and the crisis lasted a year and a half instead of a decade.

I tell you this for a specific reason. The response saved a great many people in 2008, but you cannot build a life around being saved. The people in 1932 were also sure someone would step in. So when you build a portfolio, build it for the version of the story where nobody comes. If the rescue arrives, good, you will be fine either way. If it does not, you will be one of the few who are still standing. The same goes for life.

Surviving

One man wrote the rulebook for that, and he wrote it from the wreckage. Benjamin Graham was a money manager in New York in 1929. He lost about seventy percent of his clients’ money over the next three years, and he spent the rest of his life making sure it could not happen again. His answer, in a book called Security Analysis that came out in 1934 while the wounds were still open, was the margin of safety: never pay a price that depends on things going well. Buy only what would still be fine if the world went badly. It sounds obvious. The hard part is that nobody wants to hear it in a bull market. When prices have gone up for five years in a row, paying a careful price feels like being left behind, and I have watched very smart people abandon the rule for exactly that reason, a year or two before they needed it most.

The advantage

And here is the part people get wrong. In October 2008, with the market falling every day, Warren Buffett wrote a short piece in the New York Times saying he was buying American stocks with his personal money. That autumn he also put billions into Goldman Sachs and General Electric on terms nobody else could get, because nobody else could write the check.

People read that and think the lesson is to buy when everyone is afraid. That is half of it. Buffett could buy in October 2008 for one reason: he had spent the previous five years being called old-fashioned for sitting on cash and refusing to borrow. What gave him the advantage was not bravery, and it was not a better forecast. It was that when everyone else had to sell, he did not, and so he could buy from them at whatever price they were forced to accept. The survivors get the opportunity as a gift. Everyone else is busy answering margin calls.

So the order matters. First you survive, with no debt and enough cash to live on and to buy with. Then, and only then, you get to be greedy. The people who try it in the other order do not get a second crisis.

The only hedge

You will see one of these. Maybe two. When it comes, the numbers on the screen will be terrifying and every clever person you know will have a reason why this time is the end. Remember that a man in 1932 and a man in 2009 heard exactly the same thing, and both of them were wrong.

Gala: everything passes. Whatever is falling apart around you, it will pass, and you will still be here. Be ready for the day when no one comes to help, so that when someone does, it is a gift and not a plan. And when everyone around you panics, do not run with them. Keep your head. It is the one thing nobody can take from you, and in every storm I have seen, it is what saved me.

With love,
Papá