[Commendation Awards] Risk Stems From Not Knowing What You Are Doing
``Risk comes from not knowing what you are doing.'' Warren Buffet, American investment entrepreneur, said.
Just a few months back, the world was in the midst of a big economic boom, with countries like China, India, Brazil, and Vietnam rising up as young, dynamic economies, while the USA, Korea and others found a renewed energy in their economies. Those, as they say, were the good times. The bigger the boom, the greater the potential risk of damage when the bubble bursts. Today, the world economy has been struck by a series of financial crises, be it the subprime mortgage crisis, rises in inflation, or the recent economic slowdown. It is then perhaps very apt to talk about risk in financial markets now.
What exactly does ``risk'' mean in financial terms? Suppose you invest your time, effort and money to achieve a certain goal. Simply put, risk is the probability or chance of you being unable to achieve your goal due to some uncontrollable external factors that affect the outcome.
Risk enters into an economic system when companies make financial investments in businesses. The inherent risk in such investments is that these companies could lose their money if the investments do not bring about the desired result. In order to reduce risk, one must calculate, analyze and predict the factors that affect the outcome by gathering information. However, the nature of today's global financial market complicates this process.
Risk becomes more difficult to calculate as it ``flows'' from one enterprise to another in the financial system, especially for businesses that are farther along the chain. For example, financial risk may flow from the investing company, to the bank that lent it the money to invest, to the insurer that insured the bank's loans, and finally to the shareholder of the reinsurer that reinsured the insurer's insurance. If the government bails out the reinsurer, then it simply passes on the cost to the taxpayers. In the end, someone has to bear the risk and pay the price. In the above example, the investing company directly involved in the investment has the most accurate information. However, this information then filters down to the institutions, which come into the picture later, in decreasing amounts. Thus, they are unable to predict the risk accurately.
Another unique feature of the modern globalized financial system is that financial institutions have created complicated financial instruments by mixing-and-matching underlying assets. People that invest in such newfangled instruments often have no idea about what they are really buying. If money flows around with no one knowing where it goes, how can it be possible to calculate the risk involved?
Speculation inflates the proportion of the actual risk involved. The fear of losing money makes people overtly cautious, which then starts a vicious cycle making matters worse. However, perhaps the most important thing that complicates risk calculation is that the monetary returns of the individuals or institutions that manage the money are disassociated with the returns of the individuals or institutions that actually own the money. For example, the returns earned by asset management companies and their managers are completely disassociated with the returns that are earned by investors employing their services. This leads to a moral dilemma wherein asset managers focus on maximizing their benefits as opposed to that of their clients.
In light of the above factors that complicate the process of risk calculation, what could be done to reduce risks in today's globalized financial markets.
One solution could be that financial institutions and managers receive the same amount of money, irrespective of their performance, by deciding commission percentage and paying them exactly as per the rate of return they have earned on funds managed by them. Financial companies and their employees would be a lot more responsible in making decisions about the funds they manage if their own livelihoods are at stake.
Another solution could be the creation of a stabilization fund for individual markets. The amount of money in each of these individual stabilization funds should be a pre-defined percentage of the total size of the respective markets, which should be decided separately, based on the amount of volatility that the market experiences. This fund should be employed in the market when a speculative ``bank-run'' type situation develops. This will help to prevent the collapse of financial markets and to provide security to investors. The money for such funds should be pooled from the market participants themselves.
These measures would help to solve the fundamental contradictions in the global financial markets, i.e. inaccurate decision making by managers at financial institutions because of the lack of an efficient reward system, and volatility in financial markets because of the lack of a stabilizing power. But perhaps the best advice would be to keep in mind Warren Buffet's simple homily ― ``Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.''