How Risk Aversion Is Evolving

The good news: You just managed to sell your house, you got a decent price for it, and you're sensibly renting for the time being. The bad news: So now what are you meant to do with your money? It's over the $100,000 FDIC limit -- so do you divvy it up among different banks, or buy a product like CDARS to make sure it's all insured?

Maybe you open a brokerage account and invest it all in government debt: that's safe. But what if your broker goes bust? You'd probably be OK, but can you be completely sure? These are your life savings, after all. And although you could survive a small drop in their value, you would be devastated if they were to be wiped out.

What we're seeing here is a change in risk-aversion. A year ago, a risk-averse investor was one who wanted no risk of any downside, and was willing to trade higher returns to get that safety. Today, a risk-averse investor wants no risk of wipeout, and is incredibly aware of counterparty risk.

To put it another way: A year ago, risk-averse investors would have been very attracted to principal protected notes, where you pay a bank an insurance fee for guaranteeing that your investment won't fall in value. Today, risk-averse investors wouldn't trust such a product with a bargepole, since in the event the bank were to fail, they could be wiped out. Indeed, they'd probably be happier simply buying an index fund: yes, it can fall in value, but stock indices don't go to zero.

Many investors have lost so much money right now that losing a little more is no longer their biggest fear. What we need now, I think, is some way of transforming financial-sector securities so that they go from carrying a small risk of a large loss to carrying a larger risk of a small loss. If that were possible, they're looking cheap enough right now -- especially the debt instruments -- that we might actually see some substantial inflows into the sector.

Comments

[jimhsu:]

Thus, exactly what Nassim Nicholas Taleb had in mind ... essentially we now fear kurtosis more than standard deviation. In a way, that is the right thing to do, but what effect it'll have on the markets - Main Street and Wall Street - confidence-wise is uncertain.

2008 Sep 30 12:16 AM

[Smarty_Pants:]

What the financial sector needs to return any sense of normalcy is for the risk of the government wiping out your investment at the stroke of a pen to be eliminated.

Who in their right mind is going to put any money into bank stocks or bonds? You'd spend all your time wondering which day the FDIC would choose to close your bank and screw you out of your money.

Any wonder that four sets of people have all lost their money, each with a different set of "rules" for their particular case?
1) LEH allowed to fail (after Bear Stearns was saved)
2) FNM/FRE nationalized, shareholders shafted, bondholders saved
3) AIG nationalized, shareholders shafted, bondholders saved but only after the FED thought about it for a day (giving JPM and GS a chance to buy up their bonds at a huge discount)
4) WM declared insolvent, shareholders shafted, bondholders shafted.

Unless and until "the rules" stabilize to the point where investors will be able to judge what is going to happen, confidence in the financial sector will remain at ZERO where it belongs.

People are relearning the fact that markets contain discontinuities that will happen at some point in time. Government meddling in the market to smooth over these discontinuities only leads to larger imbalances and larger discontinuities.

You can only stretch a rubberband so far before it snaps back. The more government resists allowing the rubberband to snap back and keeps pulling, the harder the eventual snap back will be.

Judging by some of the posts here on SeekingAlpha there are quite a few folks that anticipated the snap back and managed to avoid most of the negative consequences because they thought for themselves and didn't just swallow the spoonfed media propaganda regarding the markets.

2008 Sep 30 12:40 AM

[Steven Hansen:]

the easiest thing for the government to do at this time is to guarantee 100% of the deposits in a brokerage or bank account. this $100/250k limits force the account holders to raid the banks or brokerages at any signs of trouble.

2008 Sep 30 01:31 AM

[1worldcurrency:]

Storing your wealth is defensive. They don't repeat the diversification mantra for no reason. Some recession-proof dividend payers, some commodities, some energy, some cash, some precious metal. International. The capitalists have gone global, so must you.

2008 Sep 30 05:32 AM

[1worldcurrency:]

And stay away from bank stocks. If they need capital, it's not to build a new factory, it's to sink into the derivative hole.

2008 Sep 30 05:34 AM

[halconnoche:]

Again, I have no tears for the losses of shareholders. You buy stock, you take risk. If you can't handle the risk, sell. If you hold your stock in a financial institution that failed you either were not paying attention or you thought it would recover. You chose wrong so you suffer the losses.

2008 Sep 30 08:44 AM

[Tom Armistead:]

Smarty_Pants makes a good point - the largest risk for investors in financial stocks is that the government will wipe you out. After assiduouly neglecting any semblance of enforcement, regulators compensate for their failures by shafting investors.

2008 Sep 30 09:11 AM

[Smarty_Pants:]

squashnut: If there was ever a time to be defensive it is now. The feds have been interfering with market supports since 1987. Every time the economy slows down they start pumping more money and credit into the market. That excess money was used for purposes that had no real economic justification other than speculating that "prices always go up".

Now we are living in an environment where housing prices are far beyond the ability of many people to afford purchasing, stocks trade at P/Es of over 20 and are considered 'cheap'.

We are far extended from what might be considered the mean of economic reality and the reversion process is now getting underway. Those who borrowed and speculated during the climb have been caught with IOUs that they can't repay. The debt is out there and there isn't enough money or equity behind it to pay it off. Someone will take a financial beating.

Real estate prices will continue down and stocks will slump or stagnate until prices reflect true value again. Expect underperformance in most asset classes.

Prudence would suggest being very careful (ie. defensive) about where you put your money now. Avoiding unnecessary losses is the primary tenet of investing. Earning profits should be considered only when you can be reasonably sure your capital is safe from loss.

2008 Sep 30 10:28 AM

[Jackson Cash:]

Smarty_Pants makes a number of good points.

I, being GenX decided to move all my IRA holdings to treasuries after my portfolio is up almost 8% this year (riding emerging markets and energy all the way up and then selling in June). I am a long term buy and hold investor... however that strategy would have been catastrophic in my portfolio.

Also, not going to lie, I've seen this mess coming for the last three years, so I have been on an utter spending spree!

I bought the quality big ticket items (not with credit) such as a new truck, television, etc. My logic? These things could become unavailable.

I've seen this storm for long enough to not only adapt, but "invest" in the "stuff" before the stuff becomes unavailable. A little foresight and the ability to purchase debt free will continue to insulate my family from this mess... and *knock* *knock* to date it has.

The problem is that with this bailout, my "good" behavior isn't rewarded -- ITS INSULTED!!!!

2008 Oct 01 10:34 AM

[Jackson Cash:]

P.S. The "new" truck I spoke of is a 2001. Actual new trucks are a joke!

2008 Oct 01 10:40 AM

[Ellen:]

Why not a blend of gold and other precious metals and a diversification of currencies?

2008 Oct 01 02:37 PM

[Obama is Bu...:]

Despite all the Wall Street weenies screaming that the sky is falling, there are plenty of regional / local banks that did not get involved in the mortgage securitization mess -- and they do not represent much of a credit risk, regardless of what the FDIC does.

If you are really chicken, you can buy US Treasuries directly via TreasuryDirect. Your Treasury holdings are put on deposit with your local Federal Reserve Bank. There are limits on the amount you can buy via non-competitive bids (these are designed to give small investors the highest rate of an auction) -- but you can do competitive bids for just about any amount that a typical consumer might have

Now is definitely a time to be extra careful about your investments -- but the panic implicit in most news coverage is really unwarranted

2008 Oct 01 03:25 PM