Beware of Dumb Investors

In the Hutong
Catching up
0916 hrs

Reading a thoughtful article a year after it was originally written might seem folly, but given that I am still running to catch up with my backlog means that I have no choice. And sometimes, that’s a good thing.

Perusing a Martin Wolf (no relation) column in the Financial Times from 8 March 2009 entitled “Seeds of it own destruction” is sobering. As the world’s stock markets were still in their half-year-long nosedive, he noted:

“The proposition that sophisticated modern finance was able to transfer risk to those best able to manage it has failed. The paradigm is, instead, that risk has been transferred to those least able to understand it. As Mr Volcker remarked during a speech last April: ‘Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – has failed the test of the marketplace.'”

It would be very easy for me to jump on the bandwagon of Main Streeters jumping all over Wall Street and scream for better regulation of the markets. While that may be part of the answer, the other part is an old adage my mom taught me when I first started following her at swap meets in Southern California as a kid:

Caveat emptor. Let the buyer beware.

The more you read through the details of the story of the crash, the more you realize that buyers, driven by greed, willingly bought financial instruments they didn’t understand on the basis the two factors you should never trust when purchasing a financial instrument: past performance and the assurance of salesmen of the security of the asset.

To be sure, there were other factors involved, but it is illustrative that the greatest assurance against having a bubble blow up in your face is a dose of clear-headed thinking.

Which brings us to China.

Chinese enterprises and individuals are being given opportunities to purchase financial instruments about which their only knowledge and understanding comes from the people who are selling said instruments to them. They are buying real estate with the absolute conviction that property prices only go up, they never go down. And they are doing all of this believing that if a crash happened, the government would step in and bail out individual investors.

The buyers are not aware, and this is an implicit danger the government is going to have to address in a broad, systematic manner in a way that doesn’t cause a run for the exits. So the question is, how do you inform a hundred million small investors without completely undermining confidence in the markets? Especially when there is no comparable, successful model that has ever been used elsewhere?

Or, believing that to be an insurmountable challenge, and recognizing the weaknesses underpinning China’s still-developing financial and property industries, do you not even open that can of worms, and instead choose to foot the bill when the air finally leaves the balloon?

This is important. Because if there is a single factor that is more worrisome about China’s economy than its real estate prices, it is the under-informed, over-trusting, investor living in a cloudcuckooland of moral hazard.