A New Appreciation For Risk
Just like everyone else, I’m spending more time these days thinking about risk management. The scope of the risks I’m intensely interested in have changed in the last month: just like everyone else, I’m as focused on the otherwise mundane issues of decontaminating surfaces and filtering the air I breathe as I am on defending my nest egg from the wild volatility of markets.
In truth, I’m spending more time on bleaching door handles and crafting facemasks from favorite t-shirts than I am on repositioning portfolios because all of my academic training and experience in investing hasn’t equipped me with much of a playbook that is specific to pandemics.
As most of us have realized these last weeks, it is tough to hedge the destructive impact – financial, economic, and social - of a pandemic. Diversification was no panacea, and even gold (or bitcoin!) offered no shelter from the stormy markets. For many, the best – or perhaps, least bad – strategy has been to take a long view of things, sit tight, and anticipate better days when markets return to historical return patterns. But passivity feels uncomfortable.
Extraordinary public policy responses from central banks and governments have helicoptered much needed liquidity to stop the spiral of market dysfunction that punches holes in market bottoms, but as we consider the global lifecycle of the virus and coming traumas to be suffered by populations that can’t so easily maintain hygienic conditions and social distancing, it’s no surprise that so many of us have so much uncertainty about what lies ahead. Could it be that financial and economic systems have been broken?
I’m reminded of conversations I’ve had with clients in years past when I’ve been cavalier about similar kinds of extraordinary circumstances as we face now; most of those conversations had to do with allocations to US Treasuries and my assurance that if the US government couldn’t pay its obligations, we’d all have much bigger things to worry about.
Just to be clear, I’m not predicting US government default (although the potential for a huge federal debt overhanging a smaller economy is troubling.) But I was wrong to imagine that our concern for those other “big” worries would somehow relieve our own personal economic and financial concerns. And I was wrong to throw up my hands in these conversations and not entertain consideration of what seemed unimaginable.
Covid-19 isn’t really a black swan – the unpredictable, significant risk lurking in the tails of return distributions that Nouriel Roubini cautioned us about. Pandemics are predictable in the sense that the conditions for the genesis of rampant disease are fairly well understood, even if we can’t be at all precise about the timing. When this crisis eases, we’ll have opportunity to consider whether we collectively went light on the kind of “insurance” (stockpiles of supplies, vaccine development resources, etc) public health professionals know work well to mitigate pandemics, and make some ultimately political decisions about what learnings we want to take from this experience.
Investors have some thinking to do as well about their exposure and potential contributions to systemic risks like pandemics. When Mark Carney was Governor of the Bank of England, he referred to the “tragedy of the horizon” in that climate change would impose costs over a timeframe that exceeded the planning horizons of most investors, reducing the motivations for investors to factor in the changes ahead. And indeed, one plausible fiduciary argument has been to discount climate change in favor of short term economic opportunity on the theory that all that matters is investment returns for beneficiaries, without addressing whether the corrosion of all that undergirds the financial markets should be reflected in our decisions. In essence, the same hand-throwing that I did when refusing to entertain the idea of US credit defaults.
The coronavirus pandemic has rudely intruded on our planning horizons in ways that climate change won’t (in the near term) but it should demonstrate clearly to us how dramatically our worlds can change. As we emerge from this crisis, ESG analysis will never be more important. We should go beyond analyzing the damage to the economy that this crisis has perpetrated, and understand how companies’ strategic and tactical choices affect the shifting foundations underpinning the systems we rely on for economic and investment profit.
Passively standing by until the negative effects of systemic change are actually realized will be a much tougher sell for those on the front lines of client engagement. Our investment decisions matter, not only to our clients individually, but also ultimately by shaping the world we live in by directing capital to its best use. And when the fears and uncertainty associated with this crisis subside, many investors will still have a new sensitivity to risk and the potential scope of issues relevant to economic and investment returns.
Analysts and advisors alike need new proficiency in how to write and talk about these issues, how to incorporate the facts of systemic changes into analysis and strategy, and how to discern junky approaches to these issues from robust, objective perspectives. The coronavirus has shaken our clients with so many tragedies, but perhaps we can hope that the “tragedy of the horizon” is also a victim of this crisis, and that more explicit consideration of systemic risks will be a welcome addition to what we talk about with those who depend on us to steward their assets.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.