The task is not so much to see what no one yet has seen, but to think what nobody yet has thought about that which everybody sees.” – Arthur Schopenhauer

I read an article last week on why The 30-Year Mortgage is an Intrinsically Toxic Product. While the 30 Year Mortgage is primarily an American phenomenon, it made me think of something more broadly applicable.

Most individuals have a retirement portfolio full of stocks and bonds. Their incomes and home values are also correlated to the same economic growth as stocks and bonds, compounding the risk. This leaves them vulnerable to a regime change.

Home values are tightly linked with the local labor market. What determines rents is the availability and median wage of jobs (Exhibit A: the Bay Area. Exhibit B: Detroit.). The local labor market is linked to the overall business cycle. When markets go down, people get laid off and home prices decline. This means that an American buying a home with 20% down is effectively making a 5x leveraged bet on the business cycle.

If you consider the typical individual in this situation, the single biggest item on their theoretical balance sheet is the net present value of their future wages. That is, their future wages will be worth a lot more than their investment income.

Unless you’re quite late in your career or made some very savvy trades, your future earnings from your job or business dwarfs your savings and investments.

This too is generally linked to the business cycle. When markets go down, you may be the person getting laid off or with reduced income. As a result, your job or business is effectively additional leverage which is correlated to the business cycle.

Someone who buys a home where they put 20% down on a mortgage and a career in a cyclical industry (**cough** finance and tech **cough**) holding a portfolio of stocks and bonds is effectively making a 10x (or more) leveraged bet on the business cycle. (If you don’t own a home, you can take out some of that leverage, though there still may be a great deal remaining…)

While it’s anyone’s choice to do that, very very few people in that position understand that they are making that bet. There were many people making that bet that had a very rude awakening in 2008.

I believe the key from a financial perspective is to prepare for a situation where the markets drop and your income gets hit at the same time. In one lifetime, it will likely happen.

Most investors are not prepared.

Last Updated on July 6, 2020 by Taylor Pearson