Like many other industries, the financial industry has a penchant for complex terminology. Contango and backwardation, to name two – are designed to describe a particular event or scenario in ‘finance’ speak. Moral Hazard is another one, but, this time, the use of two surprisingly normal words creates an opaqueness around the overall meaning. According to Wikipedia, ‘moral hazard occurs when an entity has an incentive to increase its exposure to risk because it does not bear the full costs of that risk’. In my interaction with retail investors, I see ‘moral hazard’ as a significant underlying driver to their investment process. This can be seen in their views – bad news is good news as it triggers another wave of quantitative easing or further rate cuts stimulating markets and risk assets. Put another way, fortune favours the brave – the financially conservative or the risk averse are made to look foolish.
For a long time now, interventionist policies favoured by Greenspan in the 1990s, has resulted in an investment environment akin to walking a tightrope with a safety net – namely, it does not matter if you fall as the net will catch you. In this scenario, the net takes the form of central banks backstopping the markets with their dry powder of printed money. In fact, not only does this financial net catch you, it takes you up higher than where you were before.
In the context of the recent speculative fever and stock market volatility, this safety net is a cause of concern, as it means that we have a generation of investors whose attitude and approach to risk has been skewed.
With US stock markets recently reaching another all-time high, discussions of moral hazard and notes of caution will be lost in the noise. Who cares about prudence when you can make one years’ return in a day? My advice to investors is to create their own safety net as confidence in the markets is exactly that, confidence, and this can be a fickle emotion – strong and powerful one day and callow and nervous the next.
The shock or shocks that can trigger a significant market retrenchment or fall are often very difficult to see or predict and that is what makes them so destructive. In many cases, they start with policy failure and a loss of confidence in the institutions who are there to guide and keep us on track, and this is usually compounded by significant speculation. A good example of this would be the financial crisis of 2007/8 which led to a deep global recession. It is worth noting that we are currently seeing many of the features which when put together can morph into a significant issue – huge stimulus, a highly accommodative interest rate policy, stretched valuations and to this we can add speculation on an epic scale – played out on not just the GameStop stage – but also borne out of the uncertainty caused by the global pandemic and what ripples or waves will come from that.
Safety nets take many forms – watch your leverage, diversify, actively manage the risk of your portfolio including cash levels and know how to buy downside protection, be slightly paranoid – think what can go wrong and how would you manage that. We should remind ourselves that the stimulus being pumped into the markets is not happening because everything is rosy, and that the sole role of central banks is not to support our portfolios. This is all about managing your risk.
In previous articles I have drawn on Pink Floyd to help deliver my message. This time I would like to finish with a verse from the aptly named Tightrope from The Greatest Showman (2017, Michael Gracey).
Hand in my hand,
And you promised to never let go,
We're walking a tightrope,
High in the sky,
We can see the whole world down below
We're walking a tightrope
Never sure, will you catch me if I should fall?
Well, it's all an adventure
That comes with a breath-taking view
Walking a tightrope