From the construction companies to the real estate investors to the house flippers, a lot of people were buying and selling products that they could not afford to lose.
Too Much Risk
Entrepreneurs have a tendency to get in over their heads, borrowing more money than their idea is worth. The same thing can happen to anyone. Every business and investor has to consider the possibility of their product or investment suddenly losing a large percent of its value. A business can only spend so much money planning how to reduce the risk of a market downturn. But, in the end, they cannot avoid a downturn because of the many things that are out of their control. At most, risk can only be reduced – but never eliminated.
One of the most successful methods to reduce risk is to diversify. Diversifying an investment portfolio or the products of a business is a proven method to reduce risk of a sudden market downturn. The housing collapse will have the most impact on those that have both feet in the real estate market. For example, the smaller banks that have only 20% of their assets invested in real estate are in a much better position than Bear Stearns - who is now bankrupt.
The Risk Cycle
The problem with diversifying is that it drastically reduces your potential income. You can make a lot more money if you put all your chips into the hottest market like many of the largest financial firms did for many years. Lower returns reduce your ability to attract investors, which reduce your ability to grow your business. The problem is magnified when your competitors create a competitive advantage against you by taking on more risk. Competitive risk taking is very dangerous, because over time, everyone has taken on high risks with little cash to protect them from a pullback.
Business owners, investors and entrepreneurs need to understand this cycle and protect against the temptation to take on more risk than they can handle if (when) things slow down. If you’re an entrepreneur, that means only selling what you are able to cover. If you only have $5, than stick to selling kool-aid at the end of the driveway, and leave the house flipping for Donald Trump and Robert Kiyosaki.
The sub-prime housing collapse didn’t take this into consideration when the large financial firms lowered their lending standards and allowed people to buy houses with no money down at 100% of their value. The financial firms were fully aware of the risks they were taking (at the expense of the shareholders), but the home owners who are not business or investor savvy had little understanding of the risk they were taking nor did they have the financial capacity to cover a drop in their home value. They should not have been allowed to take on the risks they did – which now plague the global financial markets.
The Benefits Of The Risk Cycle
Sometimes a business just has to let high risk competitors take a few customers during a boom, while preparing for the bust. When the bust comes and the high risk competitors go under, your business will be there to gobble up the customers. This strategy is well understood and practiced by private owned businesses - that do not have to compete for investment dollars like publicly traded firms. This strategy provides a competitive advantage to private owned businesses - which are in the process of gobbling up market share and cheap assets. This is where it pays to stick to your guns and wait for the market to turn your way.