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I used to run financial engineering teams. So it may seem a bit weird that I am throwing stones at an approach that purports to offer risk management benefits for the layperson - namely, the use of oil hedging strategies to manage your life/work financial exposures.

This strategy is put forth by none other than Mr. Irrational Exuberance himself, Robert J. Shiller, in a recent article in Forbes (June 4th issue). Given digital rights issues (!) I am not able to provide a link but I'll attempt to accurately reflect the big picture here.

Before diving in, I am proud to note that Robert and I share an undergraduate alma mater - the University of Michigan. I'm not sure if Robert's love for risk management was seeded at U of M or not - I can tell you that mine most assuredly was not. Other seeds were planted - but that is a post for another time...

Shiller's basic hypothesis is straight out of Finance 101 - if you are going to be consuming something (like oil), and you are subject to its price fluctuations over time (in oil prices), you'd benefit from having some of this in your portfolio (through some financial instrument). Further, some people might be at greater risk to price increases and price volatility of the item in question (like the impact of oil prices on those who work in or around the auto industry and its environs), and should consider having an even greater exposure to this thing in your portfolio.

In the article, Robert reviews a variety of different ways of hedging oil price exposure, providing the pros and cons of each. All in all, an interesting academic review. And I'd expect nothing less from a man of Shiller's background and intellect.

On paper, it is hard for me to argue with Robert's theory. It is factually correct on its face. The problem with his approach, however, is that it doesn't take into account the most powerful and insidious of risks - irrational human behavior. This is something that I've written about a lot and witnessed on more than a few occasions.

Like individuals buying single stocks because they are so smart and the market is so dumb. Like gamblers making larger bets as they are losing as opposed to shrinking bet size as their assets drop. And these are just two examples of what extensive academic literature has shown is, unfortunately, human behavior. When it comes to economic decisions, we frequently do absolutely stupid things. We just do. And we can't help it. So when Mr. Shiller proposes what is, in effect, an elegantly straight-forward risk management strategy for laypeople I shudder.

BECAUSE I KNOW FOR A FACT THAT PEOPLE, IN GENERAL, WON'T BE ABLE TO IMPLEMENT SUCH A STRATEGY IN A LONG-TERM, RATIONAL MANNER.

And this doesn't take into account the inevitable basis risk that will occur between oil prices - the hedged asset - and people's wealth. Unless hedging is brutally simple and startlingly straight-forward (like swapping a fixed-rate bond into floating for its term), basis risk and perverse motives (like the desire to unwind a "winning trade" - all of a sudden the risk management rationale goes right out the window) take over. I've seen it with retail investors. I've seen it with ultra high-net worth individuals. I've seen it with Fortune 50 corporations. I've seen it everywhere.

So, bottom line: I believe Mr. Shiller's heart is in the right place. I just think he is somewhat detached from the human condition, something about which he really should know. But my advice to those non-professionals considering his recommendations: think long and hard before jumping in. Because doing the right thing over long periods of time - even if it makes sense at the outset - is awfully hard. In fact, almost impossible.

Source: Think Carefully Before Macro Hedging Your Life/Work/Oil Exposures