Risk Is Not A Four Letter Word

While Central Bankers, Real Estate Developers, Small Business Owners,  stock Market analysts rarely agree on much of anything, all appear to acknowledge that too much risk fueled the sub prime mortgage bubble that led to the very serious financial crisis that we are trying to climb out of. The consensus view appears to be fairly simple and straightforward: risk is bad.

Certainly, foolish and excessive risk taking can lead to financial catastrophe . But is all risk bad ? While excessive risk can indeed be dangerous, eliminating risk in any investing scenario is neither possible nor even beneficial.  In the space of a few years, we have seemingly gone from a period in which no risk was too big, to a period in which no risk is too small. Fortunately or unfortunately, risk can never be truly eliminated, and in fact an appropriate tolerance for risk is essential for meaningful economic growth.

Risk Will Always Be With Us

Since many more things could happen than will ever actually happen, some level of uncertainty will always exist. No matter how much care is taken in making any decision,a negative or unintended outcome is always a possibility. In short, risk will always be with us. Uncertainty may equate to risk, but that does not mean risk must always lead to danger.

As Peter Bernstein noted in his book…Against The Gods:  The Remarkable Story Of Risk, the history of the modern world is marked by a ” tension between those who assert that the best decisions are based on quantifications and those who base their decisions on more subjective degrees of belief  about the uncertain future” So while proposals for financial and corporate governance reform strive to eliminate all risk, we need to ask whether  artificial limits on all “risk” may actually create the greatest risk of all.

Consider for a moment a world in which the tolerance for risk is zero, or at least one in which perceived  risk is heavily penalized. In a risk-intolerant environment, markets would require enormous returns on equity investments and significantly higher interest rates on debt for all but the safest “blue chip” borrowers.  In such an environment, few new Real estate Developments that house industry would ever be started, funding of research and development would disappear for all but a handful of projects, and business development and Growth would be simply be priced out of the market.

If we seek to eliminate risk, who will create the next Microsoft or Google ?

The Office Building Developer and or House Developer you are living in had an element of risk….what would have happened to a Trammell Crow and other great Real Estate Developers if the Banks  had drastically changed the financing rules in  Real Estate Development ?

If we punish risk takers, will anyone invest in the next microchip or cellular technology? or fund development of the next Lipitor ? If Governments will not support risk, how will the next internet ever be created? Avoidance of excessive risk may well be necessary , but any attempt to eliminate risk would be the greatest risk of all! (credit Aquila m &a of sullivan, cromwell)

Enjoy The Day!

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1 Comment

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One response to “Risk Is Not A Four Letter Word

  1. You are absolutely right.

    Economists and savvy business people have long divided investment yields into three basis components: offsets to inflation, risk premium and actual earnings. The real net income was the latter, and staying even in buying power was the former.

    The risk premium was what the investor earned by being his own insurance company. When making many loans, for example, a lender would assume a certain number of loans would go bad, but the risk premium paid on those that were good would hopefully more than pay the losses.

    We see it in credit-cards, which seem to have a high default rate. How much is it hurting the banks? Not at all, because the “risk premium” — what banks charge in interest over the prime rate — provides far more profit than the relatively low losses they suffer.

    The same is true in home mortgages. Even today, with 10 percent of subprime loans from the bubble years facing foreclosure or already foreclosed, 90 percent of these “toxic” loans are in good standing.

    So what was the market reaction? Total panic! Investors, including the supposedly most sophisticated fund managers, fled the market, dumping their holdings and creating a self-fulfilling collapse of the securitized loan market. The result was destruction of untold trillions of value from banks, pension and mutual funds, governments and businesses. That was followed by accusations of ineptitude and fraud by financial institutions and ther high-paid executives.

    Yes for those who actually understand risk and have the assets and tools to gauge and use it effectively, this dismal market is creating billionaires of millionaires, and millionaires of many ordinary business people who can keep their heads and snap up these toxic but very profitable investments. With prices so low and the risk premium so high, it’s hard to see how these contrarians can go wrong.

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