That Rumbling in Your Portfolio? It's Real

There’s a reason markets feel more volatile: They are.

Seesaw sign at a playground
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Until about 25 years ago, when elders spoke in solemn tones about "the Great Crash," there was never any doubt about which crash they meant. For nearly six decades, there was only one Great Crash worthy of the name, and its memory forever blemishes 1929, not to mention a certain Mr. Hoover.

Then came Black Monday, 1987. Suddenly, if you were of certain age, ahem, you took pains to distinguish which crash you were talking about.

[See 4 Signs an Investment Might Be in a Bubble ]

Things got even more complicated with the Asian contagion of 1997, and the Long-Term Capital Management scare of 1998, and the dot-com plunge of 2000, and the near-death experience of 2008. And how can we forget the Flash Crash of 2010? Wasn't that some ride?

But wait. This sort of blood-curdling free-fall is supposed to be a once-in-a-lifetime event, like the transit of Venus or a federal budget surplus. How is it that someone who was in high school when Justin Bieber was in Pampers has already experienced half a dozen of them? Either we need to redefine "crash" or someone owes you some lifetimes.

If you're starting to suspect that something's amiss, Hyman Minsky is way ahead of you. Alas, he's also dead, but while alive (1919-96) and teaching economics at Washington University in St. Louis, among other venues, he developed a theory about how financial panics happen. His Financial Instability Hypothesis describes a process by which the normal, profit-maximizing behavior of borrowers and lenders leads inevitably to crisis. (If you're interested, the New Yorker's John Cassidy does a wonderful job of explaining Minsky on his blog and in his superb book, How Markets Fail.)

The panic is usually preceded by what has come to be known as a "Minsky moment"—the point when a critical mass of investors realizes that the overleveraged party is about to end, so they flee for the door—ensuring, of course, that the party ends. Market outcomes are often self-fulfilling.

But what's really interesting—and most important—is how the party gets going in the first place. Minsky held that what appear to be periods of stability are actually just lulls between storms. All the while stock prices are rising at some modest, sustainable-looking pace, and interest rates are hovering around some reasonable long-term average, the Masters of the Universe are back in the kitchen cooking up the next crisis.

[See Investing Tips for a Volatile Market.]

Not because they are evil, but because they are rational, in an Adam Smith sort of way. In a period of modest returns, investors look for higher yield, which they're more likely to get the more they can leverage (i.e., borrow). Creditors, happily obliging, scramble to outcompete each other by lowering lending standards or inventing exotic new realms of financial risk (think "synthetic CDOs"). That fuels more buying, turning a normal economy into a bubble economy through a self-reinforcing dynamic that leads inevitably to the Minsky Moment.

"The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable," wrote Minsky in a 1992 paper. "The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system."

In short, says Minsky, financial systems do not tend, like some immutable law of physics, toward equilibrium. They tend toward instability. If so, expecting financial markets to self-moderate without the occasional meltdown is a bit like handing your 16-year-old a six-pack and the keys to the car. He might come home just fine, but it's not a prudent expectation.

To be sure, Minsky has his detractors. While many economists have discovered or grown more interested in Minsky following the subprime disaster, others dismiss him. "You have to understand that to really take Minsky's ideas on board, you have to be willing to surrender some of the precepts of equilibrium economics, which is the sine qua non of most mainstream approaches," says Gary Dymski, a professor of economics at the University of California—Riverside. "And this, most economists still are not prepared to do. Minsky is still a bridge too far for most."