Partly just to think this through on my own, I've decided to write a series of posts to see if I can coherently understand and explain the current credit and liquidity crisis on Wall Street. Here goes (remember that what follows is my best understanding):
The root cause of the whole mess is that there was a lot of money trying to find a good return, and investors started to ignore risks while seeking higher returns.
In fact, that is a good place to start. We've all heard people talk about "risk and reward". There is an intuitive sense to it: if you want to win big you have to take risks. Let's think through how that occurs in investing.
Suppose that we have an investment opportunity that provides an income of $100 per year. How much should we pay for that investment? In order to be rational about it, we have to understand the risks. For instance, is it $100 every year with high certainty? Or just once in a blue moon? Is $100 a good year, average, bad? All these help us understand the "quality" of the return.
In our free market system the price of this investment is set in the market, where there are buyers and sellers. If the return is pretty risky, the investment will not be as attractive as another investment that returns the same amount much more reliably. So, what happens? The price of the risky investment will have to be lower to attract a buyer. In other words, why would anyone pay the same price for an uncertain $100/yr as they would pay for a guaranteed $100/yr?
Perhaps people are willing to pay $1,000 for the low risk $100/yr, which is a return (or yield) of 10%. If people won't pay as much for the riskier version, let's say $500, then they would have a yield of 20%. Voila! The higher risk version has a higher return (20% vs 10%), and the law of risk and return is in effect.
It is important to notice that the relationship between the risk taken and the return (or reward) received is determined by the price the buyer paid for the investment. We will return to this.
To be continued...
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Hey Paul,
Ben (my private banker ;) and another financial planner (whom we just met today) were just talking about this, and came up with basically the same reasons as you.
It doesn't interest me at all, but I thought you'd like to know. The death rate stuff I thought was very interesting though.
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