Riding the Wave of Uncertainty

The financial crisis has become a national “Whodunit?” and our public watchdogs have finally fingered the prime suspect. It’s been contained in a little black box labeled “systemic risk.” The forensics team has lifted thousands of fingerprints and the national media is doing its part rounding up the culprits. Yet, systemic risk is still an abstraction and a tough explanation to get one’s mind around.

Systemic risk technically refers to the risk that is not “specific” to one company or industry, but to the larger market or economic universe over which no one has direct control. Nature gets hit by systemic risk in the form of ice ages and meteors that wipe out whole species. But mankind created exchange markets, not God or nature, so blaming systemic risk is essentially acknowledging that the entire “system” we created and in which we operate is rotten.

There is some truth to this. During this past annus horribilis the people who should have known better engineered and amplified systemic risk. The blame falls far and wide and has incited populist rage against capitalism and free markets. But, like guns, markets don’t kill people; they are little more than highly efficient information generators and allocation mechanisms. Instead, the fault lies with some of the financial and political rules and practices we’ve adopted that impede competition, obscure information, distort incentives, and constrain our abilities to manage our economic affairs. It doesn’t help that many people made out quite handsomely exploiting this degenerate state of affairs. But let’s not miss the forest for the trees.

The political buzzwords of the day are “uncertainty” and “lack of confidence,” spoken as if all we need do is conjure up a larger Hope that will slay our fears. But uncertainty is an ever-present fact of life. It’s the concomitant of change and it’s not going away. The heightened sense of uncertainty we face today is a function of the rapid pace of technological change, which most futurists expect to accelerate. Our economic crisis truly stems from our failure to adequately manage this change. Through mistakes of both ignorance and hubris, we’ve unnecessarily magnified the risks and uncertainties of our modern world. Just think of the difficulties of valuing a house these days—with a toxic mortgage? This is what’s holding up the world economy? Certainly the Romans must have had an easier time of it. Ultimately, we need to recognize that our problems result from violating the most basic rule of nature: in a world of change, if you want to adapt and survive, diversify.

When we talk about finance we’re talking about an industry that grew out of the need to manage the risks of uncertainty. Banking began with the risks of transporting goods and money across great distances, giving rise to letters of credit. Capital markets started by pooling funds to underwrite the capital investment and risks of fleets of ships laden with goods traveling halfway around the world. Today’s financial derivatives are innovative attempts to repackage risks and allocate them according to the preferences of market participants. When we successfully manage and lower risk, risk-adjusted returns are enhanced, creating value and wealth. This is the logic behind the insurance industry as well. But when we botch it, well, we get financial contagion marked by a sharp contraction of inflated credit and economic activity. After the reset, we begin again at lower valuations.

So how do we avoid botching it? By more diligently applying the lessons of Mother Nature. The recent meltdown of mortgage-backed securities has supposedly discredited the theory of financial asset diversification. But this is a false conclusion. According to Harry Markowitz, Nobel Prize winner and father of modern portfolio theory, the financial wizards who bundled complex mortgage-backed and other collateralized debt obligations violated the first principle of asset diversification. "Diversifying sufficiently among uncorrelated risks can reduce portfolio risk toward zero," he says, "but financial engineers should know that's not true of a portfolio of correlated risks."

Basically, securitization is meant to pool uncorrelated risky assets—when one asset goes down in price it’s just as likely that another will go up, insuring the overall valuation of the pool. But since these instruments were all backed by the same worldwide housing bubble driven by low interest rates, all the risks were correlated and the securities went down like a row of dominoes.

Other critics have mistakenly applied the logic of portfolio diversification to firm diversification – arguing that diversified financial firms became too big to fail. But the era of conglomeration taught us there’s always an economic trade-off between diversification and specialization at the firm level. Unfortunately, financial firms were encouraged with implied government guarantees to test the limits of their business models. This was not the fault of diversification or caused by the repeal of Glass-Steagal.

Diversification means not putting all your eggs in one basket. It means not having all your financial wealth in your house, or one stock, one company, or one highly specialized job or skill. Diversification means investing in a varied skill set, a broad education, and social and political capital. Diversification means developing family and community networks. It means taking care of your health, buying insurance, and building self-insurance with savings.

On the national level, diversification means individuation, open competition and exchange markets – a country that marches in lockstep should set off alarm bells in our heads. This applies to economic policy as well as politics. Diversification means freedom, free will and sometimes being different. A diversified society is an interdependent, yet resilient society—it benefits from a diversity of ideas and cultures. It’s not one big cradle-to-grave social insurance pool, but the anti-thesis of universalism and nationalization. Diversification is what makes America great and what saves mankind from going the way of the dodo.