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Jumping Off a Bridge


...there are other "artificial" forces that cause the misunderstanding of risk


No, I am not ready to do that.

But say you are standing on a bridge with a bunch of friends and they all decide to jump off for fun. One by one they go, screaming all the way down. This is no little creek bridge either, this is risky and that is why it is "fun" for your friends. But as it becomes your turn and look over the edge you realize just how risky this jump is. Do you risk it?

There is a strong compulsion to, even though the risk is high (paralysis) and the reward is low (two seconds of thrill and the reputation that follows). Scott has talked about this compulsion in human behavior. I have talked about the inability of the average person to assess risk properly (the risk of terrorism versus the risk of being hit by lightening).

The bulls say that risk is currently low. Stock prices are going up and credit spreads remain very tight. Option prices are very low as are interest rates. Investors are voting with their cash and markets are usually right.

I agree that markets are usually right, at least for a while. But markets can change their mind and they can do it quickly. Why?

Mainly because there are forces at work that cause markets to incorrectly understand and assess risk properly.

The first is as explained above, the human compulsion to go with crowds. Parts of crowds can be right so the crowd grows as others join. But as things change the direction of the crowd may not turn as quickly; the momentum of the crowd is overwhelming enough to keep the main crowd going one way while the small parts of the crowd that recognize the changing conditions are exiting the other way. This causes natural volatility.

But there are other "artificial" forces that cause the misunderstanding of risk.

The first is the "other people's money" syndrom. You worked for Delta for thirty years and your retirement money was all in the company's pension plan. It turns out that the pension plan had most of your money tied up in Delta stock. If you had been making that decision yourself you probably would not have risked your retirement on the performance of Delta stock, but the pension manager and the company had ulterior motives for risking your retirement on the performance of the company's stock. They perhaps knew that it was too risky, but they were willing to take that risk with your money given the high reward to the company as a result (higher corporate profits). This occurs throughout the financial system: pension managers making credit decisions, analysts making stock recommendations, financial planners investing your money, bankers making loans, etc. They tend to skew more toward return (pressure to perform) than toward taking less risk and protecting your capital.

The second is government intervention. Politics has everyone disgusted these days and politics is money and power. The Federal Reserve is pumping M3 at full throttle right now right before elections. Coincidence? Perhaps it is but it does not matter. Keynes himself alluded to the power of money creation as having its roots in its influence over consumption and savings. People by themselves have a certain propensity to consume and save. Keynes believed that the heart of the "cycle problem" was people's too-conservative (at times) desire to save rather than spend. It was and is the government's "right" or "obligation" to change that. Full employment would only result from making sure people didn't save too much and spent too little. Creating credit out of thin air makes the currency worth less and nudges people to spend more and save less. Doing so over many years conditions them to save nothing and spend everything. Keynes (I hope at least) never came to the ultimate conclusion that eventually it would force people to borrow to spend as they do now.

These forces over time cause risk to be underestimated and they work cumulatively. I view higher stock prices, low credit spreads, low volatility, extremely high debt, and very high liquidity as high risk because the probability is that they will be reversed first by the smart parts of the crowd and then the whole crowd itself.

No positions in stocks mentioned.

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