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Financial intermediation reduces volatility.  In bull markets, demand for financial intermediaries drops.

by David Merkel, Aleph Blog

Ordinary people do well if they have a budget and stay within it.  They do even better if they save and invest, but really, they don’t know what to do.  Market returns are like magic to them.  They don’t know why they occur, positively or negatively.  Life would be best for them if a mutual financial company gave them smooth returns 0n a regular basis, and absorbed all of the market volatility over a market cycle.  That would be hard for the mutual financial company to do, because they don’t know what the ultimate returns will be, so how would they know what smooth returns to credit?

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There is a reason why banks, mutual funds, money market funds, life insurers, and defined benefit pension plans exist.  People need vehicles in which to park excess cash that are more predictable than direct investing.  Set an average person free to make his own investment decisions with individual bonds an stocks, and he will make incredibly aggressive or scared moves.  Fear and greed will seize him, making him sell low, and buy high.

That’s why entities that reduce volatility, whether absolutely or relatively, whether short-run or long-run, exist.  But there is seasonality to this: average people seek intermediaries during and after bear markets, when they have been burnt.  After losses, they seek guarantees.  That is often the wrong time to seek guarantees, because often the market turns when average people are running.

During bull markets, the opposite happens.  When easy money is being made by amateurs, the temptation comes to imitate.

  • If my stupid brother-in-law can make money flipping houses, so can I.
  • If my stupid cousins can make money buying dot-com stocks, so can I.
  • If my stupid neighbor can make money buying gold, so can I.

First lesson: don’t be envious.  Aside from being a sin, it almost always induces bad investment and consumption decisions.

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