Measure Your Risk: Too Big to Fail or Too Many to Bail?
On October 30th, the S&P 500 went 28 consecutive days without achieving back-to-back up days. That tied the longest streak since the Great Depression. Over the last 10 days the indicator of the US economy has been more volatile than Bitcoin. When markets fall it is only natural people turn their attention to risk.
Having a diversified portfolio of investments remains the soundest way to manage risk. The idea is that different investments carry different risks. Holding a variety of investments therefore spreads the risk so that it is unlikely that all the instruments will fall at the same time.
That is the theory. In practise “once in a life-time” market crashes are occurring with increasing frequency. The 2000 “Tech-wreck” crash and the 2008 Financial Crisis are the most recent. Under these conditions, supposedly uncorrelated markets find themselves falling at the same time. Why is this?
The problem is the interconnectedness of the markets. The following info-graphic tells the story:
The interconnectedness of the markets has not undermined portfolio diversification as the best means to mitigate risk. It has just forced prudent investors to ask the next question: how do I diversify away from the financial system itself?
Every investor is going to answer this question in a different way depending upon their circumstances and inclination. However the key to making the right choices is the difference between asset-based instruments and belief-based instruments.
Asset-based instruments are those that derive their value from other underlying instruments. They include equities, bonds, tracker funds, property funds and derivatives.
Belief-based instruments are those whose value is self-generated — they have value because people believe they have value. They include precious metals and other commodities, currencies, real-estate, and some crypto-currencies such as Bitcoin.
The need for asset-based instruments to rely on another instrument as the basis of their value is one of the primary reasons for the interconnectedness of the financial system. Banks, brokers, investors buy and sell these instruments to each other. This creates a dependency where the value of one institution depends upon the value of others. If one should fail, like a sweater unravelling, this can have catastrophic consequences for the financial system as a whole.
Asset-based instruments can only further embed a portfolio in the risks of the financial system. They offer no diversification away from these risks.
In contrast, belief-based assets are more like stand-alone systems. If there was market collapse tomorrow gold, or oil would still have value. As long as the Internet was still up Bitcoin would still have value. House prices would fall in a market crash, but houses would not become worthless as people still value a roof over their heads.
Think of it like this: why is the Internet so robust? It started life as a military grade communications system that would survive a nuclear strike. The robustness comes from the lack of dependence of the system on any single component. If a cable, router or server goes down, the message is simply rerouted through the parts of the system still standing.
Belief-based assets are like this. Yes, they can lose value. Some will lose all their value. But the loss of any of these instruments does not jeopardise the entire system.
This is the strength of diversification — having enough stand-alone instruments in one’s portfolio so that if any one does go down, the others are left standing. That is to say, portfolio theory, the bedrock of prudent investing, depends upon an Internet-like environment of stand-alone belief-based instruments. No matter how “low risk” your mutual fund is supposed to be no asset-based instruments can reduce the risk of financial collapse.
The dependencies of the financial system have bred fragility. This is built into the system because of the nature of asset-based instruments. In the past governments have been at hand to bail out the system with more money. But will governments always be able to play this role?
“With risks shifting to shadow banks — hedge funds, insurance firms, independent broker-dealers and other intermediaries that aren’t deposit-takers — critics have questioned whether governments will bail out non-bank institutions in the next crisis.”
We have had “too big to fail”. Are we getting to a point of “too many to bail”? Governments have lowered interest rates to below zero. They have massively increased the money supply with quantitative easing. What is left? Should an investor place their faith in government bail-outs or in portfolio diversification?
The 2008 Financial Crisis spurred Satoshi Nakamoto to develop a peer-to-peer means of payment. The goal was to enable diversification away from the systemic risks of an interdependent financial system. Today’s scarcity of viable belief-based investments has again led to innovation. Bitcoin Enhanced is the first investment-strategy whose value is belief- rather than asset-based. Like Bitcoin itself, if the dependencies of the financial system start to unravel, investors can now participate in a blockchain token that will still be standing even if there is complete financial meltdown. That is what diversification is supposed to be about. Belief-based instruments enable you to diversify away from the fragility of an interdependent financial system.