By: Dividend Sensei
I’m listening to a great audiobook right now, “More Money Than God” about the history of the hedge fund industry. What is most telling is that because of the massive use of leverage, often an event that may have no direct link to one asset class, will see that asset class hammered because hedge funds that own that asset class will get hit with margin calls and become forced sellers desperate to obtain capital to cover their losses.
For example, if a hedge fund uses 100X leverage to make a big bet on the Yen rising against the dollar, and then US interest rates rise, and the BOJ slashes rates even more negative, than the Yen will crater.
The margin call they get will force the hedge fund to sell bonds, which could cause bonds to drop enough to trigger margin calls at other hedge funds. The brokers that lend these funds money can start to get nervous and the margin calls end up rippling out around the world, to thousands of funds who hold trillions in assets, backed up by a tiny fraction of actual investor capital.
As losses mount, trillions in assets that were built up over years, suddenly need to be sold ASAP, creating a liquidity crisis as all the funds become sellers, and there is no one to buy, even as prices crash.
Many hedge funds own stocks, and these two will need to be sold in a panic to raise the funds to keep the fund solvent.
Which can result in an unexpected black swan, a major global market crash that strikes like lightning out of a clear blue sky.
Suddenly perfectly good stocks can be trading 10%, 20%, 30% cheaper, for no reason other than over extended hedge funds need cash NOW!
That is why I say that long-term, buy and hold DGI investors have an edge over Wall Street. If you never use leverage, and you invest with a long-term time horizon, with a focus on secure, and growing dividends, then you have no reason to panic over a sudden 30% crash.
Rather you can become the “smart money” by taking the other side of the trade. You give the desperate hedge fund manager your money, and lock in a quality, sky-high, and growing yield on quality REITs, and then laugh all the way to the bank.
This has happened in pretty much every decade, as global finance has become more interconnected, and the use of leverage by hedge funds has only grown.
It’s also why buy and hold, DGI investing will never become obsolete. Wall Street is focused on short-term profits, so they need to take crazy risks to keep getting their obscene pay.
That greed ensures that they will never learn, only think they have. They’ll come up with a new quant based risk hedging system that they think will allow safely leveraging up in ever greater amounts, to be able to generate fantastic returns from tiny arbitrage opportunities in any one of hundreds of markets around the world.
In reality they will never succeed. If one fund comes across a unique way of making money safely, then over time others will learn its secrets.
Those funds will copy the strategy and the profits will decline over time. Which means that the hedge funds will use higher, and higher, leverage to keep the good times rolling. At some point a black swan liquidity crisis will be triggered and result in a chain reaction of panicked margin calls that will see world markets crash.
The bottom line is that bubbles, and crashes will never be truly done away with. They are created by human nature, first greed, then fear, and will be with us always.
If you can learn to be calm, and conquer your own fears, then you can avoid ever becoming a forced seller at the bottom, and take these fools’ money.
A good investor is one that saves as much as possible and puts it all into a portfolio of low cost, index ETFs and just sits on it.
A great investor is one that takes advantage of market panics, and crashes to load up on cheaper, higher-yielding shares, AND THEN sits on it.
Do this long enough and you too can, and WILL, crush 90-95% of “Wall Street Pros” and grow richer than you ever thought possible.