Everyone's Rational Until They're Not
Private credit is booming and regulators are nervous, oil and war are back in the headlines, and beneath all of it sits the real question: how do we actually make decisions, and why does that decide our returns more than any forecast?
Private credit has exploded, and regulators are now waving a flag. Local private credit loans have grown from around $35 billion to roughly $250 billion in a decade, with over half tied to property development.
Handling volatility starts with calming down. The first useful move is noticing when you are reacting emotionally rather than logically. Quick is not the same as emotional.
Two systems drive every decision. System 1 is fast and automatic, System 2 is slow and effortful, and we run on System 1 far more than we like to admit. Understanding that is an edge over most investors.
Manias are built one imitative decision at a time. A friend's property win, a few experts, then the media and the dinner-party humble-brag. That is how a boom assembles itself before the pendulum swings back.
The real long-run compound return is far below the headline. With the S&P now around 207% above its long-term trend, this is not the moment to assume the good years continue uninterrupted.
A busy week to open on. War and oil are back in the same sentence, and whenever they are, energy prices and shipping become the transmission line into everyone's portfolio, whether they own energy stocks or not.
Closer to the plumbing of the system, private credit and margin debt keep climbing. Both are forms of leverage, and leverage is the thing that turns an orderly pullback into a disorderly one. We also touched on the global push back toward nuclear power, a genuinely important long-run energy story that is quietly gathering pace.
And at home, some Australian property promoters look to be panicking. When the people whose living depends on rising prices start changing their tone, it is usually worth noting. It rarely happens at the start of a boom.
We flagged the risks in private credit a while ago, and now the regulators are sending the same message: be very careful. At the same time we have watched a number of stock promoters and fund managers spruiking the higher yields on offer, which is often a signal in itself.
The regulators' concern is straightforward. The sector has grown very fast, it is relatively new, and a lot of investors have piled in chasing yield without a clear view of the risk underneath it. The scale of the growth is the part that stops you.
That is more than a sevenfold increase in ten years, and the concentration makes it worse rather than better. On the reporting we walked through, more than half of all private lending in Australia is tied to property development and construction, the exact part of the economy already under the most pressure. New, fast-growing, yield-chasing, and pointed straight at the most stretched sector. That is a combination we would rather watch from a distance.
None of this is a view on any specific fund or product, and it is not advice to buy or sell anything. It is a general caution about a corner of the market where the risk and the marketing have drifted a long way apart.
So how should you respond to volatility? The first step is to calm down, and to do that you have to first recognise that you are reacting emotionally rather than logically. There are moments when reacting quickly is the right call, but quick and emotional are not the same thing.
If you understand how your own decisions actually get made, you have an edge over the 95% of investors and fund managers who never think about it. The comfortable assumption baked into economic theory is that every investor is rational. In the real world, that is about the least accurate description of how people behave with money.
Runs quickly, with little effort and no sense of voluntary control. It cannot be switched off.
Covers expert intuition, learned heuristics, memory and perception. It knows the capital of Russia without trying.
Constantly feeds impressions and feelings up to System 2. Most of the time we simply accept them as our own reasoning.
Handles deliberate, demanding work: complex computation and anything without a ready-made answer.
We identify with System 2, but System 1 is usually doing the driving while we believe we are being deliberate.
Only fully engages when System 1 hits a surprise it cannot resolve. Attention orients, then judgement finally kicks in.
This is why markets sometimes move so fast. An announcement surprises the market, and instead of switching on System 2, analysts fall back on System 1, their built-in biases and heuristics, and price the news on instinct. System 1 is not the enemy. It just needs supervising, and the investors who supervise it are rare.
Individual decisions are rarely as individual as they feel. They are shaped by influences that arrive in order of closeness: family and friends first, then experts, then the general media, all layered on top of beliefs we absorbed long ago. Philip Ball's work on how crowds behave describes the same pattern from the outside.
Take the classic Australian decision to buy an investment property. System 1 sets the frame before any analysis begins: our parents owned one and "made money," property feels safe and tangible, unlike a share market we do not understand and never discuss at dinner. Then a friend buys a place and reports a smooth, pleasant experience. A few experts start recommending property, largely because other experts are. The media reports rising prices and runs more coverage. The renovation shows multiply.
Each of those nudges us to look closer, but with the bias already installed. We skip the base rates, ignore the people who lost money, and never compare the returns against the alternatives. Once enough people are in, momentum takes over and prices accelerate.
Rising prices become their own evidence. People check their net worth, retell their own and others' success stories, and the dinner-party humble-brag does its quiet work of confirming every decision. Much of the new wealth is really new credit, borrowed against assets that have simply gone up in price. Then a transition phase arrives. The pendulum swings back. A few sell and get out. Others hold on and wear the consequences, and if the exuberance was widespread enough, everyone feels it in some form.
Here is the part the finance industry would rather not dwell on. The headline number everyone quotes is an average annual return of roughly 8 to 10%. The return you actually compound, once the drawdowns and the flat decades are included, is a great deal lower. The long-run market is a sequence of above-average stretches followed by below-average ones, not a smooth line.
Recreated from Advisor Perspectives / VettaFi data, real inflation-adjusted S&P composite on a log scale. The market swings a long way above and below a roughly 2% real trend, and today sits about 207% above it, one of the largest gaps on record.
The same story shows up if you tag every major top and bottom since the 1800s. Look at the run of highs and lows and the annualised return earned between them. The good stretches are real, but so are the long stretches where an investor who bought at the wrong point waited a decade or two just to break even.
| Year | Milestone | Change | Years | Ann. Return | With Dividends |
|---|---|---|---|---|---|
| 1906 | High | 333% | 29.3 | 5.1% | 10.1% |
| 1921 | Low | -69% | 14.9 | -7.5% | -2.0% |
| 1929 | High | 396% | 8.1 | 21.9% | 28.4% |
| 1932 | Low | -81% | 2.8 | -33.2% | -28.5% |
| 1937 | High | 266% | 4.7 | 20.4% | 26.2% |
| 1949 | Low | -68% | 19.8 | -5.6% | -0.2% |
| 1968 | High | 413% | 19.5 | 8.7% | 13.3% |
| 1982 | Low | -63% | 13.7 | -6.9% | -3.0% |
| 2000 | High | 666% | 18.0 | 12.0% | 15.3% |
| 2009 | Low | -59% | 8.6 | -9.8% | -8.1% |
| Now | — | 521% | 17.3 | 11.2% | 13.2% |
Recreated from inflation-adjusted S&P composite monthly averages. Note the lows: real annualised returns of minus 5% to minus 33% for anyone who bought the prior high and sat through the next leg.
Both pictures say the same thing. There are good times to invest and bad ones, and right now, well above trend and late in a long run, we are getting into dangerous territory. This is exactly why rebalancing matters so much: trimming what has run hard and topping up what the crowd has abandoned is how you work with these cycles instead of being carried by them.
The through-line this week is behaviour. Private credit is a crowd chasing yield without weighing the risk. The property cycle is System 1 building a mania one imitative decision at a time. And a market 207% above trend is what it looks like when a lot of people decide, together, that the good times simply continue. The edge is not a better forecast. It is knowing how you decide, staying deliberate when everyone else is running on instinct, and rebalancing through the cycle rather than betting the line stays straight.
As always, this is general information about how we read markets and decisions, not personal advice tailored to your circumstances.
Steve: When promoters get loud about yield and quiet about risk, that is the tell. Private credit into property is a lot of risk wearing a comfortable label.
Tom: You cannot switch System 1 off, but you can build the habit of pausing before you act. That pause is most of the edge.
Jacob: The market has spent most of history below a prior peak. If you internalise that one fact, high valuations stop feeling like a reason to relax.
This newsletter is for informational purposes only and does not constitute financial advice.
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