unknown risk = unknown price

One thing that fascinates me about the credit crisis, sharemarket plummet, global woe and gloom is the fact that the average person has basically no control at all over this process.

They can be diversified in markets and asset classes, do all the ‘right’ things, and still lose lots of money. They can have bought a house with a reasonable mortgage, and although they probably wont go bankrupt, they will still have a rapidly decreasing net worth.

And the funny thing was, no-one (except possibly, Warren Buffet, when he expressed his dislike of financial derivatives in 2003) predicted the problem. WTF? No one? I mean… this is like a once every 100 year massive train wreck. Were there no signs, no screeching of breaks?

Evidentally not. So what does it mean? Well, it seems to mean that assessing risk in share and property markets, the main vehicles for investment outside banks, is … well… essentially unknowable. Not only for the average joe, but also for the experts in the system. And the unfortunate corollary of that is that if risk is unknowable, then price in unknowable as well.

Which makes rational investing basically impossible. So everyone should invest in gold and of course, AK 47s to protect it. Where can I buy shares in Kalashnikov?

unknown risk = unknown price

6 thoughts on “unknown risk = unknown price

  1. But, that’s not quite true. For a few years now you, Kelvin and I have been talking about how the housing market was way over valued. I’m sure I told you about a graph that showed the average house price in ratio to the average income. It had bounced around a certain ratio, as you would expect, until the early 2000’s when the house prices started to far outpace the incomes. So we knew a house price crunch was coming. Kelvin got commercial property rather than residential for exactly this reason, and I’ve had no money in property. I even remember trying to talk people out of getting big mortgages a few years back. Apparently, “nobody ever loses money on property, and if we don’t get in now we will never be able to afford a place”.

    The bit we didn’t see was that this would get some banks into trouble, and then the whole stock market would crash as people got nervous. I knew there was volatility in the market, so I’ve been sitting on cash for over a year now, but I didn’t expect such a big crash. I thought banks were more reliable than that. Clearly some were not.

    So no, I don’t think nobody could have seen this coming… WE saw it coming, at least the property side of things. It’s like 1999 when Kelvin and I were trying to work out whether or not to buy put options on the NASDAQ as the market was clearly way way over valued.

    I suspect people would do much better in markets if they forgot about all the technical stuff and stock tips and following the latest news… and just looked out for the bloody obvious.

  2. Right, but thats exactly my point. I thought the stock market was… reasonably valued in most cases, certainly not way overinflated.

    We certainly saw the property issues, but I didnt forsee the impact on the stock market. Which means … I had no idea about the actual risk profile of companies I bought, because I couldn’t factor the flow on effects in.

    Essentially, at any given point in time, you have no idea what the market has or hasnt factored in to the stock price, so… how do you assess the risk? Especially when there are risk factors that for all intents and purposes are unknowable?

  3. Kerry says:

    So how do you cross the road each day? Or take a plane flight? How do you assess the risk? Just as many of the risk factors are for all intents and purposes as unknowable as those involved in the share market.

  4. Well, its to do with the reality of the risk. Is it a “what if” kinda risk, which to means to any reasonable person they dont actually exist (eg: what if im crossing the road and I get hit by a meteorite), or a ‘real’ risk (getting hit by a bus).

    If its a ‘real’ risk, then you do a risk assessment and mitigation (assessment=are there lots of busses, have people been hit by busses before doing what Im doing, mitigation=look both ways).

    Then you evaluate if youre happy with the mitigation strategy, and has it reduced your assessed risk. Then you take a step.

    In the sharemarket, the history of sharemarket crashes indicates the risk is real. So, risk assessment… hmm. How would you do that? How could you predict that the mortgage derivative market would have such a big impact on Apples share price? Essentially impossible.

  5. I thought the stock market was a bit overvalued. The P/E ratios weren’t all that good. Which was sort of my problem: the housing market was scary, but the stock market wasn’t all that great either… so what was I to do? At the moment I think that stocks are trading at a discount due to high volatility. People want to stay out and see where things go from here. If I’m right then in a few years or so most of the current stock losses will be recovered.

    Risk is always difficult because it’s about unknown stuff by definition.

  6. Kerry says:

    The problem at the moment is that the underlying system is becoming impacted – normally this isn’t an issue. An extreme instance would be the Russian revolution – it completely rewrote the rules of life in Russia and could not have been predicted. If you’d owned land in Russia at the time you would have been screwed. Using the traffic analogy, you can assess the risks for normal events but if you are biking along you can’t do anything about the person who swerves across and wipes you out because a bee entered their car and they are allergic to bees.

    Personally I think now is a good time for hunting out bargains in the area of infrastructure (eg electricity generators) where the share price has fallen because of overseas investors withdrawing their money from NZ holus bolus.

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