The Concept of Risk
My hunch is that investors generally look at market analysis a lot more than they think about market philosophy. If this is true, then it is rather unfortunate; for how can one ascertain a ‘good’ or ‘bad’ analysis without a solid of understanding of what it takes for it to be ‘good’ or ‘bad’? A problematic symptom of this is a general confusion about ‘risk’. It is often said that ‘such and such is risky’ or ‘he took too much risk’ or even ‘this is less risky than that’. But what do these statements really mean? And if we can understand what they are supposed to mean, then are they even intelligible? In short, what is this concept of risk?
‘Risk’ expressed in a Mechanical Sense:
First of all, let me say that I have no problem with the notion of risk when it is used in a strict, mechanical sense. That is, if someone bought a stock for $100, then he might say that he’s risking $100. I think that this kind of statement is legitimate as far as it goes (as the purchase of a commodity or a bond for $100 would have exactly the same ‘risk’ in this sense). This usage of the term ‘risk’ is really true by definition; just as a square must have four equal sides, one risks the entirety of the outlay paid for any investment.
However, one should note that this way of viewing risk is very limited. After all, losing $100 in 1930 meant something entirely different to losing $100 in 1927. Meaning, those $100 could drastically change in value (implying a great variance in the value potentially lost with the risk). Risking $100 in a bull market in money (against things) may be perceived as different to risking $100 in a bear market in money (against things).
However, regardless of the definitional usage above, I think that people often use the term ‘risk’ in a different way. Indeed, a way in which the commodity and equity above would be inherently ‘riskier’ than the bond. I contend that people have some kind of value judgment about ‘the way prices should/will move’, and that this value judgment dictates their view on risk.
In the Wall Street Journal (Europe) the other day, David Enrich wrote about the FSA’s attempts to supervise foreign firms in the UK:
The Financial Services Authority’s goal is to prevent certain companies from exploiting European rules to set up banking and brokerage operations that the agency views as potentially risky because they use a structure that doesn’t face tough local supervision..
The FSA doesn’t appear to be targeting foreign firms across the board, but is focusing instead on institutions that seem to have riskier profiles or operate in areas that aren’t closely supervised by their home-country regulator…
While the FSA lacks the legal authority to force banks to convert their UK structures, it has ways to pressure banks to make the switch according to bank executives, lawyers and former FSA officials…
“You can make life difficult” said a former FSA official. He recalled dispatching a team of inspectors to pay repeated surprise visits to the London branch of a foreign bank that the FSA worried was financially unsafe. The bank eventually pulled out of the UK, he said.
Now, I could be wrong, but I don’t think that this use of the term ‘risk’ is meant in its mechanical sense (as described above). Instead, there seems to be some kind of statement made about the type of portfolio, and value judgments are made upon that type. Indeed, whatever the basis of that judgment is, the FSA clearly believes in it with ferocious vigor. After all, their thuggish tactics of ‘dispatching a team of inspectors to pay repeated surprise visits’ suggests that they have great conviction in this notion of risk.
Each Individual Views Reality with a Uniquely Defined Lens:
A corollary of the simple statement that we can only perceive what is perceivable reveals a deep, Kantian insight about how we view things. That which one perceives is both subject to the nature of what one is perceiving and one’s own apparatus of perception. Given that – at any time – each individual can only occupy space uniquely (that is, you can’t be in the same place as someone else at the same time), we must conclude that each of us brings our own belief structures and past experiences to the table. The lenses – so to speak – with which we view reality differ in at least this respect. In this way, our subjective views of risk (in the sense of how prices will move) must also differ.
So, when the FSA declare something to be ‘risky’ and something else to be ‘less risky’, of course they are really saying is that they think it is risky/not risky. And so, risk cannot be said to be an inherent property of specific assets, as any declaration about risk is subject both to the asset and the person’s means of perceiving it. Their personal belief structures and past perceptions are the things viewing the asset as ‘risky’.
The Markets Weed Out the Good Risk-Takers from the Bad:
Now, barring the possibility that the FSA are a bunch of super-human deities, this makes for a rather perplexing problem. In regulating based on their subjective view of ‘riskiness’ (whether they acknowledge the subjectivity or not), they are essentially saying that their perception of markets is the right one, and that the subjects of their regulatory predation have – in some way – the wrong perception (else why is regulation deemed to be necessary?). That is, their implicit declaration is that they have the correct perception of markets that supersedes all others, and that this perception should be enforced upon others.
The irony should be evident, for any such people (that think they have the exclusive ‘right perception’ on the nature of prices) are almost certainly bound to be wrong (admittedly – by my perception). Nobody has that kind of knowledge, and that is why the markets – themselves – are the best regulators of risk. In a legitimate and true marketplace, bad risk-takers soon become irrelevant whereas good risk-takers survive and prosper.
The Paradox that Surrounds Consensual Notions of Risk:
When dealing with markets, there is an intimate connection between the way prices eventually move and our perception of how they should move. This makes for a foxing and paradoxical arena – where consensual notions of risk defeat themselves.
An example of this can be seen in long-term US Government bonds (see chart from multpl.com below). On the eve of their historic bull market, they were deemed to be ‘certificates of confiscation’ – i.e. the riskiest and last place you’d want to be. Yet that was on the eve of an epic bull market that was truly a passage to safety. Arguably, we’re nearing the end of that bull market, and – alas – people use the term ‘riskless’ to denote US government bonds. It is quite possible that we’ll laugh at this label in 30 years time.
As Hugh Hendry often says (paraphrasing); “safe harbor in financial markets lies with the most contentious asset”.
Nobody has a monopoly on the future, and no one has knowledge of things that is separated from their apparatus of perception. For this, and many other reasons, the best and fairest way to deal with uncertainty is with the inbuilt regulation of the market (rather than human regulation of it). Quite simply, winners should win and losers should lose.