The scene: A barbershop in downtown San Francisco. It's October 1999, and stocks are reaching new highs, led by technology. Investors are wildly optimistic. In a few short months, the market will enter into its longest sustained downturn since the Great Depression. The barber has nearly finished cutting my hair and is telling me about his investment portfolio.
BARBER: …and I'm telling you, I've already made more than 100% on each of these stocks. I'm just frustrated I didn't own bigger positions all along. This week I'm going to put my entire portfolio into them. My broker tells me three stocks aren't enough to "diversify," but who needs diversification in this market?
ME: Well, technology stocks in general have done great this year, but do you think those companies can continue to do so well? Three stocks total seems a little risky for your entire portfolio.
BARBER: Hey, I already missed a lot of upside by not owning more earlier this year. Plus, this internet stuff is continuing to boom, which means these stocks are gonna keep ripping.
ME: Maybe. What exactly do these companies do again?
BARBER: I'm not sure. One of them works with IP authentication something or other, and another one has this special do-hickey that speeds up network traffic. I can't even remember what the last one does, but I don't think I could explain it even if I did.
ME: I guess I don't get it. Product technology aside, most of these internet companies are years or decades from projected profitability, yet people are willing to pay astronomical prices for their shares.
BARBER: You don't have to get it! That's the beauty of this whole thing. Just look how these stocks have done—they go up every single week. And as more people keep using the internet, the stocks will keep going up. What more do you need to know?
ME: It just seems strange to abandon a diversified investment strategy to focus your entire portfolio on a speculative—and unprofitable—segment of the market you don't understand very well.
BARBER: You're thinking about this too hard. Haven't you heard the analysts on CNBC? This is the NEW ECONOMY! If you want to cash in, get on board with these new technologies. Take my advice—you'll thank me.
BARBER: OK, now for the haircut, that will be $10, young man. Wow, I wish I still had a thick head of hair like yours!
The scene: A barbershop in a suburb of San Francisco. It's October 2007, eight years later and in the midst of a media-proclaimed "credit crisis," which has been a headline story all year, despite a steadily rising market. Fear is everywhere. Once again, the barber has nearly finished cutting my hair and is telling me about his investment portfolio.
BARBER: …so I finally dumped everything last month. I'm telling you, this subprime mess is going to take down the market and everyone with it. The only safe place for your money right now is under a mattress.
ME: Well, subprime was maybe a bit overextended, that's true. But a wide scale collapse? Seems a little overly pessimistic.
BARBER: Just look at these crazy financial instruments…CDOs or whatever they call them. They're melting down by the truckload and causing a major credit crunch in the financial sector. I don't know how the banks will survive.
ME: Are you sure you understand those instruments? On the whole, collateralized debt obligations (CDOs) have actually led to greater stability in the banking system, not less. And, in terms of credit liquidity, spreads on corporate debt are right where they were at the beginning of the year, so borrowing is still on pretty favorable terms for most companies.
BARBER: Listen, I don't understand all this technical jargon, and I don't care. All I know is there's a lot of these bad loans floating around out there, and sooner or later someone has to take the hit.
ME: I guess I don't get it. Subprime only accounts for about 10% of all mortgages, and only a handful of those are in default. And look at last week's earnings reports from the major investment banks, who were some of the largest holders of this exposure. Seven of eight actually reported a net profit for the third quarter, even after taking the losses on their mortgage holdings. Doesn't sound like a crisis to me.
BARBER: I don't want to hear your fancy finance explanations. All I have to do is read in the paper about declining home prices and these failed hedge funds. The writing is on the wall—Americans have borrowed too much money, and stocks will pay the price.
ME: It just seems strange to abandon a diversified investment strategy because of a small segment of the financial market you don't understand very well. In most industries, earnings have continued to come in at or above expectations, and broad measures like GDP and unemployment show we're in good shape economically.
BARBER: Haven't you heard the analysts on CNBC? The credit CRUNCH!? The liquidity CRISIS!? Those don't sound like good things go me, and I'm parking my money on the sidelines until all of this uncertainty is gone. Take my advice and do the same—you'll thank me.
BARBER: OK, now for the haircut, that will be $15, sir. And if you haven't noticed, this hair on top is getting pretty thin. You might want to consider picking up some Rogaine.