A development project created a number of condominiums. A city ordinance required that some of the units be sold at cut-rate prices to low-income people. Business is generally slow for new real estate agents so, freshly minted Brent met the low-income guidelines. He was able to buy a condominium for about $20,000 below market price (the law prevents him from reselling for two years).

When it came to financing, Brent wanted a mortgage with the lowest monthly payment. Accordingly, he picked an adjustable-rate mortgage (ARM). After three years, Brents interest rate will change. Brents ARM produces a low payment. It also produces risk for my nephew. With interest rates near both theoretical and historical lows, those who have ARMs face the risk that their payments may rise substantially.

I asked Brent if he feared rising interest, and he replied by saying if my mortgage interest rate is adjusted upwards, Ill just sell my condo. Sound reasonable? It may, but it is not for the same reason that the Dow Jones Industrial Average lost 500 points in one day in 1987. The problem with Brents strategy is that hes not the only one with that strategy. Many people with ARMs may think they will sell prior to big mortgage payment increases, which is the functional equivalent of an elephant stampede trying to get through a small door opening-all at the same time.

To understand this risk it is necessary to understand the systematic effects of everyones strategy. Sometimes it pays to do the same thing as everyone else. In the United States, for example, it is obviously good to drive on the right side of the road. Similarly, it is easier to swap word processor files around if we all use the same programs (nowadays that program is Microsoft Word). As we have learned, however, finance is a game where it often pays to avoid the herd.

The 1987 stock market crash was made more severe by the common use of portfolio insurance. The stock market was soaring in the early part of 1987, and people wanted to get rich. Some people were also worried that stock prices were too high. They could have reduced risk by selling some of their stocks, or by a whole host of financial strategies such as selling short or buying puts. The trouble with all of these techniques for

reducing risk is that they also reduce the gains. What was a greedy but scared investor to do?

So-called portfolio insurance provided the answer. With it, the buyer could enjoy all the benefits of owning stock and also be protected against losses-or so the argument claimed. Heres how portfolio insurance worked. Stuff the portfolio with stocks. This provides the fuel for fat returns if stocks rise. The insurance on the portfolio was a plan to sell stocks if they declined. As stocks would sink, the investor would rapidly shift out of stocks and into safe bonds.

In theory, portfolio insurance had all the benefits of stock ownership without the risk. If stocks began to decline the investor would magically be shifted out of stocks. This seemed like such a great idea that firms sold this insurance and many investors bought it.

What happened to those who bought portfolio insurance? They got massacred in the 1987 stock market crash.15 And they almost destroyed everyone else, too. In the second half of 1987, the stock market began to decline. As stocks declined, those who owned portfolio insurance sold stocks, which in turn caused prices to fall further. This selling culminated in the Dow Jones Industrial Average losing over 20% of its value in one day. The decline in the 1987 crash in percentage terms was almost twice as large as the 1929 crash.16

Investors portfolios turned out not to be protected from the 1987 crash. The theoretical analysis of portfolio insurance assumed that markets would move gradually. In the real world, prices did not move gradually, but rather took huge steps down. Investors who thought they would exit stocks after small declines found themselves selling at precisely the wrong time.

If only one person had used portfolio insurance it might have worked fine. Because the strategy was common, however, the system built upon itself to create a selling frenzy. Those with portfolio insurance made the worst mistake possible in mean markets; they bought at the top, and put themselves in a position where they had to sell at the bottom.

Similarly, if Brent were the only person with a sell if rates rise

strategy, it might work fine. However the truth is exactly the opposite. One-third of new mortgages are adjustable-rate mortgages, which is near an all-time high.17 The prevalence of adjustable-rate mortgages makes the sell my place if interest rates rise strategy risky. If interest rates continue to rise, then millions of homeowners will be looking to sell when their mortgages adjust. This is unlikely to be a profitable time to be a seller.

When bad things happen they often appear unavoidable. In reality, however, the required steps to avoid ruin need to be taken much earlier. This is something that investors need to know, and also something that would have helped a man named Robert Brecheen.

At around 9 p.m. on August 10, 1995, Robert Brecheen tried to commit suicide by overdosing on pain pills. Mr. Brecheen was rushed to the hospital and revived by the administration of powerful drugs. At 1:55 on August 11, just five hours later, Mr. Brecheen was executed by lethal injection in the Oklahoma State Penitentiary.18

Mr. Brecheen was sentenced to death for committing murder in the first degree. After years on death row, all of his appeals had been denied and his execution loomed. Rather than let the state kill him, Mr. Brecheen decided that he would control the time and manner of his own death by committing suicide. Even in this, he failed. Mr. Brecheen got into a situation where he had zero control over his life. He was not able to even decide how or when to die.

Investors who are on the wrong side of mean markets face outcomes that are far less severe than execution but similarly inflexible. Those who buy at that top are often forced to sell at the bottom. A key to making money in mean markets is to retain control of the time of ones buying and selling.

Adjustable-rate mortgages remove control of when to sell a home. Those with adjustable-rate mortgages may be pressured to sell their properties at the same time as others. Thus, those who seek to profit from market craziness should avoid adjustable-rate mortgages.