The unwilling risk-takers

By Felix Salmon
September 30, 2009
Chris:

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Comment of the day comes from Chris:

The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium…

The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.

This is possibly a very beautiful and elegant explanation for the extreme profitability of investment banks. They charge their clients a lot of money to take risk off their hands, and then they transformed that risk, using sophisticated financial engineering, into instruments which didn’t, on their face, look risky at all, and which could easily be sold to risk-averse investors. Bingo, massive profits.

Financial complexity and innovation, on this view, are essentially tools of obfuscation. And it’s easy to hide risks when risk-averse investors want debt-like products which retain their face value: such instruments tend to have very low volatility, and so look and feel as though they’re low-risk, even if they’re full to bursting with enormous amounts of tail risk. The answer, as I’ve said many times in the past, is for risk-averse investors to be willing to take a small amount of explicit market risk, and to move towards safe equities (utilities and the like) and away from debt. Because if they go to an investment bank asking for safety, they’re likely to just get hidden risk in return.

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