Felix Salmon

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.

Steve Waldman has a corker of a blog entry today, blaming a large part of the present crisis on "investors’ childlike demand for safety". It’s a very powerful insight.

Think of the enormous emerging-market central bank reserves that everyone was so worried about for the past few years, and which caused the global imbalances which are now only slowly beginning to unwind. Substantially all of them were invested in triple-A paper — either Treasury bonds or Agencies. But there were private investors too who wanted the highest possible level of safety; with Treasuries all snapped up by the Chinese, they developed an insatiable appetite for structured products. MBSs, CDOs, ARSs, CPDOs: it didn’t matter what they stood for, the only thing that mattered was AAA.

To put it another way, the problem wasn’t high-risk financial products, it was low-risk financial products.

The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was "safe", so who cared what it was funding?

There is a case to be made that small bank depositors should not have to worry about whether they’ll be able to get their money back: hence the FDIC. But beyond that, Steve is surely right that there are altogether too many people, including a large number of enormous institutional investors, who fetishize safety to the point at which they don’t want to bear any risk at all. But capitalism doesn’t work without risk. If the providers of capital aren’t willing to take risk, the system breaks.

Here’s a heretical idea: what if the USA losing its triple-A credit rating wasn’t the worst thing that could happen right now, but rather the best? What if we got rid of the idea entirely that there is any such thing as a "risk-free rate of return", and came to realise that all investments involve risk? Come on, Moody’s; have a go, S&P, do your worst! Maybe then investors will start doing their own homework when it comes to risk and reward, rather than blindly throwing money at anything with a "risk-free" or "triple-A" label.

The problem with auction-rate securities was maybe this: that stockbrokers felt a huge amount of pressure to reassure a bunch of investors with, typically, six-figure sums of money to invest that their money was perfectly safe and perfectly liquid. There’s no such thing, and frankly people should stop being so cavalier about money-market accounts as well. If you’ve got lots of money, good for you. Now go and invest it sensibly. Don’t ask for zero risk. That way lies trouble.