When it comes to asset management and
other investment matters, risk is commonly perceived as a static notion that is
expected to remain unchanged over long periods time. In life cycle investing,
for example, the investor’s risk profile is expected to change only very
gradually, starting off from being relatively aggressive during the earlier
years to highly conservative as the person approaches retirement[1].
This gradual and stepwise shift in risk typically occurs over a time span of at
least 50 years.
In contrast, the risk observed in
markets is never a constant, constantly swinging like a pendulum somewhere between
risk taking and aversion[2].
The most visible measure of the level of risk in the markets at any given time
is volatility: low volatility tends to accompany a greater appetite for risk and
vice versa.
Through this basic understanding of
risk, and with the various tools at their disposal, governments, and more
particularly monetary authorities, have been attempting to fine-tune the investor
risk appetite. One possible measure of their success is to take a look at the prevalence
and severity of market bubbles over a given time frame. If they happen to occur
less frequently over that same time frame, it could be indicative that a
certain policy may be having a positive.
If we take global markets over the past
20 years and compare them to earlier periods, we can see that the frequency,
severity and duration of market crises have actually risen significantly[3].
What makes this observation somewhat troubling is that it coincides with a
period in which the Fed and other central banks have adopted a more transparent
“forward guidance” approach in their policies.
The “forward guidance” approach
postulates that by communicating in advance what your actions in the future are
likely to be, and by following through on your promises, you will invariably
contribute to reducing volatility. This is simply because it is believe that such
disclosures eliminate a major source of uncertainty for the markets[4].
The forward guidance that Greenspan
instigated when he became chairman of the Fed in 1987 was further emboldened at
the time by what became known and the “Greenspan Put”[5].
Announcing in advance the actions that the Fed was planning for the future
instilled a false sense of confidence amongst market participants. The “put
option” just made things worse by instilling a culture of “moral hazard” that
encouraged what eventually turned into reckless risk taking. Investors were under
the illusion that they would be bailed out in the event that things got nasty.
How is it then that such eminent
scholars as Greenspan and Bernanke both failed to take note of this dangerous
paradoxical effect of their policies? More importantly, how is it that same
erroneous policies continue to be applied to this day? To give an answer
requires a better understanding of the psychology of risk.
You have to keep in mind that the human
brain is a product of thousands of years of evolution through natural selection[6].
We apparently all have a built in, hard-wired “fight or flight” response that tends
to activate when facing perceived dangers. This is purely a biochemical
reaction in which our entire organism is summoned for possible action. With
higher cortisol in our bloodstream, heart rate accelerates, our muscles become
tense and we are more alert.
Not surprisingly, when that same risk presents
itself in a more regular fashion, making it easier to anticipate, we adapt to
it, and the “fight or flight” response fades away. If, on the other hand, it is
mainly random and therefore unpredictable, we tend to remain fully alert until
it stops or we are consumed by exhaustion. The interesting point to retain in all
this is that the response is very similar to the risk averseness that tends to accompany
a market crash or an environment of heightened uncertainty[7].
[1] Target dated investment funds offer asset
class diversified investments where the risk profile of the fund evolves over
time until the fund “expires” at a specified date. The investor typically selects
a target date fund depending at where in the investment life cycle he or she
happens to be.
[2] Market risk is influenced and determined by a
confluence of economic and psychological factors and the way in which those
factors interact. Because of the infinite number possible combinations, and the
impossibility to predict what factors will matter at any given time, it is
close to impossible to anticipate how risk is likely evolve over time.
[3] See
“Facing the Reality of Bubble Risk” by Nicholas Sargen for a more in-depth look
at the levers of market bubbles.
[4] Before all this, when Paul Volker was at the
helm of the Fed, markets had no option but to second-guess what he was thinking
about doing next. The uncertainty raised volatility, which in turn made investors
more risk weary and thus reduced complacency.
[5] This term was coined to describe the
automatic, almost knee jerk policy of substantially cutting short-term rates
the moment a crisis occurred. The aim was to raise the investor appetite for
risk.
[6] I’m assuming here that you are an adherent to
Darwinism.
[7]
See “The Hour Between Dog and Wolf: How Risk Taking Transforms Us,
Body and Mind.” by John Coates.
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