A Brief Primer on Risk Management
We say ‘brief’ because first hurdle one has to clear when assessing any type of situation is whether or not there is risk involved. Risk can appear anywhere – even crossing the street. Such simple acts are rarely given much consideration, but our brains are constantly analyzing risk/reward quotients for various activities.
Often, when looking at investments, we give in to perceptions rather than realities. Most capital asset pricing models, for instance, rely on the use of ‘the riskless asset’ in their various formulae. Does such an asset exist or is it akin to the ‘Giffen good’ concept in mainstream economics texts?
If anything has become clear since the turn of the century, it is that there is no such thing as a ‘riskless asset’. US Government debt, the de facto ‘AAA’ rated standard bearer of zero risk has become fraught with uncertainty. Once we break the mental model that there are in fact safe havens, we can start to have a meaningful conversation about risk and reward. Before we launch into a series of short briefs outlining the various types of risk, we need to hit some assumptions. These assumptions are especially true for Americans and anyone who holds depreciated US Dollars in any real quantity.
The Dollar as the reserve currency of the world. At present time, this is an arrangement of convenience more than anything else. Why would anyone want a paper ticket (or mostly digital now) that has no intrinsic value, does not act as a store of wealth (Thanks Msrs. Powell, Bernanke, Greenspan, et al), and has developed such an animus about it?
Answer: Because that’s what we’ve always done. The population of the world, in vast majority, hasn’t lived through a time when the Dollar wasn’t the standard bearer. So it is human nature to assume this will continue – despite mounting evidence to the contrary. If we make the leap that the Dollar is vulnerable, then so does all the debt that bears its name. Goodbye says the ‘riskless asset’. What does that do to our models? We need new ones if we’re going to accurately assess risk either qualitatively or quantitatively.
So, with that rather unpleasant bit of business done and the idea of the riskless asset disposed of, we’ll embark on a rundown of the various types of risk for a typical investor in an environment that often looks more like a war zone than a place to nurture wealth.
We’ll try for one each day and, failing at that, to accomplish this task within the next few weeks. If you looked at the chart of the US National Debt that was posted yesterday, you can probably imagine there is an essay forthcoming. The media isn’t covering the out of control accumulation of debt – passed on to our children and grandchildren – so our rather small group of deficit hawks will do their job for them. Stay well.
Sutton/Mehl