Over the next week or two I shall attempt to explain why the recent crash was inevitable and why anyone in the financial community could have, and should have, seen it coming. Let’s start with basics first. Most will learn nothing new here I'm sure, so apologies in advance for the first post.
Risk vs reward.
It sounds like a catchphrase, something we’ve all heard, but it is the fundamental balance that underpins every single decision sentient life makes – from grazing in the open plain where predators might be lurking, to running a red light or ordering something new on the menu.
Each being has its own natural balance that applies to them. Some are adventurous, some are naturally timid. Some people like sky-diving; some people like diving. Some people like to invest spare cash in the stock market; some prefer to just put it in an interest-bearing account.
There is even a children’s fable that tries to teach the extremes of each type of behaviour: The Tortoise and The Hare. Countless movies are morality tales of taking too much risk in the long term.
Game shows also work on the principle of risk vs. reward, none more so than Deal Or No Deal which works purely on probabilities, expected outcomes, and the individual’s assessment of risk vs reward.
Imagine you are given a choice: either to be given USD 500k here and now, or toss a coin where if it is heads you get USD 1m and if it is tails you get nothing. The expected, or average outcome is the same – USD 500k. Some people will take the gamble for the bigger prize, some will not. What if the here and now is only USD 250k, or only USD 100k? On paper you would be choosing the smaller expected amount, but it’s guaranteed. Each person has their own balance. A multimillionaire for example will probably take the initial gamble because the second USD 500k is ‘worth’ the same to him as the first USD 500k. A struggling young couple looking for their first home will almost certainly take the first option even if it’s only USD 250k because it’s more life-changing to them than the extra money they could win.
The financial markets, not surprisingly, work exactly the same way. Treasury bills and government bonds offer a low rate of return compared to other ways you could invest your money. Why? Because they are, or at least were, considered as risk-free as it gets. The value of these T-bills and bonds has decreased in the last year (and thus the higher profit or return you get when they mature since they are cheaper to buy now) because there is more risk (or perceived risk to be accurate) these days that the government will default on the payment. A higher risk *must* mean a higher reward for the balance to be maintained.
Imagine the risk-free rate was 3%, and there was an investment that could be made, also risk-free, that could generate a 10% return. Banks could borrow money at 3% and invest it at 10% and not have any risk. Money for nothing it seems. Well, no. What would happen is that the cost of the investment (eg share price) would increase as demand for it increased until the price was such you would only get 3% return overall. If the price for this investment was initially USD 100 per share, with a guaranteed USD 110 back, the price would almost automatically rise to around USD 107 per share to get a 3% return.
In fact the investment would never have been offered at USD 100 in the first place unless the offerer was an idiot. It happens, of course, but the market quickly corrects.
Now before anyone points it out, no one can borrow money at a risk free rate. The above is just a simple illustration. There will always be an extra premium to be paid because the lender is lending the money to someone that themselves is not risk free – there is always the possibility of defaulting. The higher the loan, the higher the chance of a default, and therefore the higher interest that is charged. The poorer the person lending or the less security they can give the lender, the higher the premium. That’s why banks have a high premium for mortgage lending, and the higher the initial deposit you make, the lower the interest rate that is offered.
I say perceived risk above because in real life it’s just an estimate. The same is true in most cases of the perceived reward. Every investor not only has to try and work out the risk and reward, but also whether that risk is worth taking. Share prices go up and down as individuals continue to reassess their estimates and rebalance accordingly.
Most people have heard of hedge funds but do not know exactly what they do. Few, thankfully, think that it’s part of a reforestation scheme. In general, hedge funds invest in things that are not highly correlated with the stock market. Some hedge funds even invest in things that will go up in value if the stock market goes down. Some investments are highly risky in their own right (and therefore some hedge funds generate great returns and some dive into the ground). Hedge funds even advertise the level of correlation (or more precisely lack of) they have with the stock market as an advertising tool. It is one of the first things an investor will ask.
Many investors like to put some of their money into a hedge fund because if the stock market crashes, not all of their investment will go crashing down with it. They are spreading their risk, hedging their bets, hence the name.
The hedge fund market has grown massively over the last five years – not because they are making great returns, but because the perceived risk of the stock market crashing grew and grew and so more money was diverted into them to cushion the oncoming blow whilst still making hopefully decent returns.
The diversion of money itself was a sign that the financial community saw it coming, or at least perceived that it might be coming, if I’m being generous.
Risk vs reward. It is what drives the markets. It is the only thing that drives the markets.