On Risk Aversion

by: Felix Salmon posted on: August 08, 2008 | about stocks: DIA / QQQQ / SPY    
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I've been thinking a bit more about the downside of risk aversion, which is something that Steve Waldman brought up yesterday and which I then applied to the ARS fiasco, among other things. The problem is that it's entirely natural, even when it isn't a good thing, and so I've been wondering a little a related question: given that risk aversion has always been around, how has capitalism dealt with it in the past?

Recall that it was too much risk aversion (it even had a name: "portfolio insurance") which caused the 1987 stock-market crash. And it's too much risk aversion which causes any kind of liquidity crisis, from a generalized reluctance to lend all the way to an outright bank run.

Right now, investors are really panicky, because they're coming to realise -- quite possibly for the first time -- that there's a large amount of risk built in to all of their savings. If you just kept your money in a savings account, it was historically perfectly safe. But with the dollar collapsing, that's no longer the case. If the world's reserve currency is also a weak currency, what is a risk-averse investor to do? Other stores of value -- buying commodities, or other currencies -- involve increasing your risk profile, so while they might make sense, they're not a great place to go psychologically. And as for the safety of housing, well, the less said about that the better. Suffice to say that it probably would be a safe investment, if it weren't for the fact that it was so highly leveraged.

In many ways, the financial system is actually based on risk aversion. That's why there are more bonds than stocks: with a bond, you're promised your money back, in full, with interest. Stocks have a significantly higher return than bonds, which results in the equity premium puzzle. Even after accounting for risk aversion there's a puzzle there; before accounting for risk aversion, it doesn't seem to make any sense at all to buy bonds rather than stocks.

Risk aversion is so all-pervasive that capital-struture arbitrageurs are never going to be able to make it go away. And as we've seen it extends even unto the very largest investors, entities like the Chinese central bank, with trilion-dollar balance sheets. (Maybe if they hadn't been so risk-averse, buying only US Treasuries and their ilk, they wouldn't have lost so much money when the dollar collapsed.)

Stock-market investors, too, are risk averse -- even those who you might think wouldn't be. I remember talking to a very successful investment banker once, who was being offered downside protection on her stock portfolio by her private bank. Of course, as a successful investment banker, she priced out the product: she went to a friend working in equity derivatives, and worked out how much it would cost to replicate wholesale. But once she did the math and decided that her private bank wasn't ripping her off, she was very serious about buying the product. It's called the endowment effect: Once you have money, you're more scared of losing it than you are excited about seeing it grow.

Risk aversion is a great way of explaining business cycles. When everything's going up, people spend much less time worrying about the risk of things going down. So their risk aversion dissipates, or else it's simply overwhelmed by their fear of losing out on potential upside. Nothing lasts forever, however, and so when the bull market ends, the risk aversion comes back with a vengeance. Things are going down, so worrying about things going down is entirely natural. And there's precious little opportunity cost to playing it safe, either: in fact, the safest investments tend to outperform.

For that matter, risk aversion is also a great way of explaining the success of Warren Buffett. He's an insurer at heart, and insurance companies make their money by insuring people against the risk of loss. He's happy taking big, billion-dollar risks, so long as they're priced correctly. And he loses no sleep when the securities he's invested in fall in value: if anything he likes that, because it just means they're getting cheaper and better value should he want to buy more. The vast majority of us, however, simply don't have the psychological ability to behave like Warren Buffett. (And, of course, Buffett's a multibillionaire with a relatively modest lifestyle whose children will inherit relatively little: he can easily afford his attitude to risk.)

You can't make risk aversion go away: it's hard-wired into what it means to be human. Maybe all we can do at this point is sit back, and wait, and have faith in a higher power. It's called greed.

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Felix Salmon

Felix Salmon

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This article has 3 comments:

  •  
    truthinvesti
    ng
    Aug 08 07:12 AM
    My Website
    Enjoyed this article . My free website has racked up double digit growth on the long positions this year because of exactly what the author said.There is LESS RISK buying PG at 60 or BUD at 47 then there was when their stocks were 15% higher. Also fighting the"trend" s foolish.As much as the financials have declined ,it is a FACT that many financials will NEVER recover from the sub prime debacle.Of course the trick is to determine which ones and AVOID them.Easier said than done
  •  
    JasonC
    Aug 08 02:03 PM

    The writer claimed at one point "If you just kept your money in a savings account, it was historically perfectly safe". This is completely false.

    Bank failure was the most common symptom of financial crisis for most of the long term past. Depositers regularly lost significant sums of money. Nationalizing this risk with deposit insurance does not eliminate the risk of loss, it merely generalizes it to all assets that pay off fixed amounts of the currency in question.

    Do what you will capital is at hazard. Anyone who understands what capital is and where its value comes from will realize this. The value of anything depends on its role in a whole network of social relations, any of which can change tomorrow.

    There is a risk averse way of meeting this value uncertainty, but it isn't to find the magical mcguffin of the riskless asset, which does not exist. It is, instead, to run a "matched book".

    In ordinary finance, the term matched book refers to maturities of assets and liabilities, and means ensuring that an asset matures at the same time as any liability is expected to fall. It protects against changes in interest rates and their term structure, secondarily it ensures liquidity, assuming all the assets are actually realized (which they won't be, in general - "capital is at hazard"). But the idea has a more general sense.

    Which is, to match your asset profile to your projected future liability profile, including your consumption.

    If your electric bill is $100 a month, buy electric utilities sufficient to pay you $100 a month in dividend payments. If you spend $150 a month on gas, buy oil stock sufficient to pay you dividends of $150 a month. Buy your house free and clear. Same for food, etc, through your entire list of expenses.

    Then you profit as an owner whenever the price of anything increases, as much as your own prices for that service increase. You are harmed by reductions prices on the capital side, only where and as your own costs for services fall.

    Naturally, almost nobody does this. It is instructive to first calculate the amount of present capital value you would need to do it, however. If you don't have that much capital in that industry, then you are a "renter" of that service. If you own more capital in an industry than you make use of that industry personally, you are acting as an entrepeneur and projecting that you favored positions will increase in relative value in the future.

    Whenever your investments are not matched to the industry profile of your own consumption demand, you are exposed to swings in total consumption as demand shifts from industry to industry. Naturally, you also have a time profile of demand - lower than earnings in some years, higher in retirement, etc.

    When you put everything in bank savings, you are predicting that everything else will underperform bank savings, which in general will only happen in a horrible deflation, in which your own bank doesn't fail.

    Bank savings are loans to your bank. If they are typically profitable for the bank, then its stock is a better investment than the loan. Holding cash is a bet against the very institution you are trusting with your capital.

    Most cannot match their profile of demand with their assets exactly. But then many confuse their entirely voluntary departure from anything like that profile of investment, with some evil alien risk that is supposed to be someone else's fault, and that the gubmint is supposed to fix or something.

    If you own real estate for 10% down to multiples of your total net worth, but wouldn't dream of speculating in commodities, and drive a big SUV - then you bet the moon that real estate will outperform oil. You could just as readily have rented the house and owned oil futures with borrowed money, in exactly the same amounts. But because lots of people are doing the first and few the second, oil prices rising are thought a calamity, and house pricecs falling are thought a calamity, as though it were chiseled in granite somewhere that no one shall own oil with borrowed money, but everyone shall own real estate with borrowed money.

    Notice, that isn't a recommendation to buy oil futures. It is a diagnosis of a kind of cognitive dissonance bordering on madness in contemporary financial commentary.

    Take responsibility for the risk profile of your assets. Do not back into an allocation merely because it is conventionally done, or because someone told you it is safe (nothing is). In general, diversification and matching your own needs are a less risky thing in every real sense, than crazy one-asset bets that magic asset class X and only X, "is safe".
  •  
    truthinvesti
    ng
    Aug 09 09:52 AM
    My Website
    Jason C is right.If you do not KNOW how to invest money during BAD TIMES you should not be paid to do it.On my free website we wrote an artcle about sector rotation out of commodities into consumer goods and those who followed it made great buys on PG KO KFT PM KMB and many others
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