Just How Exposed Are Your Investments?

Just how exposed do you think your investments are to the risk of loss, even catastrophic loss?

You may have a term deposit that pays you interest. You may have bought mutual funds. You may have invested in a tracker fund like the S&P500. If you have made any of these or similar investments you are rightly concerned with risk and wish to minimize it to the fullest possible extent.

So what I am going to say next is not going to make you feel very good. But bear with me.

In 2014 the global derivatives market was estimated to be worth $1.2 quadrillion.[1] Derivatives are part of an asset class where value is based on the value of another underlying asset. For example a futures contract is based on the future price of an asset such as corn or gold or a currency.

The $1.2 quadrillion was just an estimate because nobody really knows how big the derivatives market is. That means the risk of the market is unquantifiable — literally unlimited.

Now, you will say “But what has that to do with me? Exotic derivatives are exactly why I have listened to my financial adviser and taken a prudent, diversified approach to my investments.”

The issue lies in the nature of derivatives themselves. Because the value of each instrument is based on the value of some other instrument, all derivatives are dependent upon other financial instruments. Because banks, brokers, insurance companies, governments and other financial institutions buy and sell these derivatives to each other, each of these institutions is dependent upon others to maintain themselves as a solvent going concern. The current financial system is literally made up of these relations of mutual dependence.

Have you ever had a sweater where you pulled the wool and the whole sweater came apart? The sweater is a system of mutual dependence.

[1] https://money.visualcapitalist.com/all-of-the-worlds-money-and-markets-in-one-visualization/?link=mktw

What about the domino effect — lining up all the dominos so that as one falls it triggers the next and that triggers the next and so on until they are all down? That is a system of mutual dependence.

The 2008 Financial Crisis was exactly this situation where the whole system began to unravel. Steve Eisman, one of the people who saw the crisis coming, described the situation like this:

“’There’s no limit to the risk in the market,’ he said. ‘A bank with a market capitalization of one billion dollars might have one trillion dollars’ worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!’ The failure of, say, Citigroup might be economically tolerable. It would trigger losses to Citigroup’s shareholders, bondholders, and employees — but the sums involved were known to all. Citigroup’s failure, however, would also trigger the payoff of a massive bet of unknown dimensions from people who had sold credit default swaps on Citigroup to those who had bought them.’”[1]

[1] Michael Lewis The Big Short, page 263.

Steve Eisman

So the problem for you if you have term deposits, mutual funds, tracker funds or any other “safe” product is that you are still exposed to the unquantifiable risks of the financial system simply by virtue of being part of that system.

“But I have diversified,” you say. “I have deposits, funds and real-estate.” The question is not whether you hold diverse investments but whether any of these investments are outside the current financial system. In order to find out list each of your investments and ask of each one three questions:

Did I buy the investment from a third party, e.g. a broker or bank?

Is the investment something that has value in its self or does its value derive from another asset?

Did I borrow to purchase the investment?

If there is a “yes” answer for any of these questions then the investment remains part of the financial system and is exposed to unlimited and unquantifiable risk. In the words of Warren Buffett:

“In my view derivatives are financial weapons of mass destruction carrying dangers, while now latent, are potentially lethal”

Warren Buffet

Lastly, just to complete the state of fear and depression, the mutual dependence of institutions of the financial system not only exposes you to unquantifiable risk, but the first domino to fall can be ANYWHERE in the system. In 2007–2008 it was sub-prime mortgages in the United States. The next time…no one knows. That is why a quick glance at the news headlines on Google almost any day of the week gives stories such as:

The next financial crisis is closer than you think

World economy at risk of another financial crash, says IMF

Why Italy Could Be the Epicenter of the Next Financial Crisis

How Interest Rate Hikes Will Trigger The Next Financial Crisis

Trade tensions could trigger another global financial crisis, but …

The next financial crisis will be brought on by inadequate regulation …

The problem is that any of these experts may be right. In a system as interdependent as the financial system we just don’t know.

So what can you, the prudent, risk adverse investor do?

In this post I hope I have shown that it does not matter what investments you have made. If they remain part of the financial system you are still exposed to the unlimited risks of that system. Please do not take my word for it. Do your own research.

In the next post I will outline a way of classifying financial instruments so that you can diversify away from this black hole of risk. Stay tuned the sun breaks through the storm clouds!