Sunday, May 21, 2017

Stock hedges, home insurance, and our misunderstanding of risk

"If you own stocks without a hedge, it's not rational." So says the world's most famous student of risk Nassim Nicholas Taleb in a recent interview with Bloomberg as many of the world's stock markets hover near all-time highs. "It's like buying a house without insurance," he explained. "We have tail risks today that we didn't have before, and every day it gets worse."

"Tail risks" refer to the possibility of unusual, rare, catastrophic events, often of a nature that cannot be anticipated or even imagined. Such events are frequently dubbed black swans, a term made famous by Taleb's book called The Black Swan.

So, what is the perceived difference between houses and stocks and what does that tell us about how we judge risks elsewhere in our lives and societies? First, houses. Houses are very expensive consumer items or investments or both, depending who is buying them and why. Taleb's point is that the value of a house will not track the market if the house burns down.

Every homeowner understands this and buys insurance. In fact, the bank requires insurance if the home has a mortgage. And, that's because, of course, homes don't rebuild themselves if they are destroyed.

The companies underlying stock listings, however, are not obliterated by a market crash. Of course, some companies may disappear if the crash is followed by an economic downturn; but the thousands of companies that make up the exchanges do not all evaporate.

Stocks have historically recovered after losses, even extreme losses. So, the hedging Taleb is suggesting is really about timing. Can an investor afford to wait for the rebound before having to cash in? If Taleb's concerns are borne out in the next few years, many near retirement or already retired may be answering this question.

(The history of stock markets reveals a mixed picture. Some rebounds to previous highs have occurred within months or years. Some have taken decades. The Japanese stock market has yet to revisit the peak of 1989 and currently stands at about half the level of that peak.)

With housing and stocks we have two different kinds of risk, both of which can be hedged so as to prevent a severe loss of net worth. Why do most people only hedge one, namely the home?

Now, most investors diversify their investments. They own some stocks, some bonds, some real estate and perhaps some other investment such as a business they control or an annuity. While diversification, if done properly, can reduce risk, it is not true hedge.

Hedges are designed to go up in value in inverse relation to the decline in value of the instruments they are hedging. Owning gold as a hedge against a stock market crash may or may not work. Gold is not a true hedge in this instance and in the last market crash, it plummeted along with stocks. Stock options that necessarily rise in value as stocks sink are a true hedge.

Of course, homeowners insurance does not insure us against a decline in real estate prices. It turns out that one can actually now hedge that risk with the appropriate financial instruments. But few people do that for their family homes. In fact, people rarely envision having to sell their homes for less than they bought them.

It is this one-way bias that links people's perceptions of both homes and stocks. It is almost inconceivable that any of us might be forced to accept catastrophic losses if only we can hang on long enough. What this view presupposes is that the future will look like the recent past (that is, the last century or so). It will be one of growth, growth, growth. Growth in population. Growth in economic output. Growth in financial wealth. Growth in the energy supplies needed to make all the other growth happen.

It would indeed be a black swan if growth failed to appear or was so stunted that few people obtained any benefits from it. (Has the second scenario already arrived?) But the twin crises of energy depletion and climate change make such a future ever more likely. These crises aren't hidden and they aren't cyclical. They are advancing in such a way that the risks of both are not staying neatly tucked under the "tails" of the bell-shaped distribution curve of possible outcomes. Our current actions make them inevitable.

Things could change. Human societies could revolutionize the way they live so as to avert disastrous climate change or fossil fuel depletion (that is, depletion without adequate alternative energy). But, it seems that such a revolution would be more akin to a black swan than any rendezvous with energy or climate Armageddon.

We've convinced ourselves as a world society that such outcomes are so unlikely that we are making what amount to token efforts to avert them. Renewable energy is being deployed rapidly, but not rapidly enough to replace the current fossil fuel infrastructure soon enough to prevent a climate catastrophe (and perhaps an energy insufficiency).

There is no insurance policy that will protect us against catastrophic climate change. We cannot get our habitable climate back on any time scale that matters to humans once it's gone. The insurance policy is us, that is, changes in our behavior and our technology done quickly enough to matter. There is no other hedge that will help us.

Kurt Cobb is an author, speaker, and columnist focusing on energy and the environment. He has been a regular contributor to the Energy Voices section of The Christian Science Monitor and is author of the peak-oil-themed novel Prelude. In addition, he has written columns for the Paris-based science news site Scitizen, and his work has been featured on Energy Bulletin (now Resilience.org), The Oil Drum, OilPrice.com, Econ Matters, Peak Oil Review, 321energy, Common Dreams, Le Monde Diplomatique and many other sites. He maintains a blog called Resource Insights and can be contacted at kurtcobb2001@yahoo.com.

4 comments:

Joe said...

... the twin crises of energy depletion and climate change...

The crisis of energy depletion is our hedge against the crisis of climate change. Right now the growth curve is flattening due to recent periods of high costs for energy and other resources. It will soon roll over and then begin to decline as we go over the EROEI "cliff".

It is almost certain that the structure of the global market economy cannot survive continuous recession and will collapse as soon as it becomes clear that growth is never coming back. So we have good reason to hope that the climate will be saved by economic collapse before catastrophic warming happens.

If the hedge against climate change is decline in energy/growth leading to economic collapse, what is the hedge against collapse? I suggest that food producing land, together with the skill to help it produce, is the best hedge. There are others, such as joining a criminal organization willing to steal or extort food from farmers, but I hope that most would prefer to be a farmer rather than a criminal. The only hedge against criminals is the cooperation of farmers.

In any case, the collapse of industrial agriculture will be hard on everyone and fatal for many. There aren't enough hedges to go around for 7.5 billion of us. Get yours now.

SteveB said...

"Hedges are designed to go up in value directly in relation to the instrument they are hedging."

Did you mean in inverse relation, Kurt? And that would be when "the instrument they are hedging" is going down, right?

Kurt Cobb said...

SteveB, Thanks for catching my error. I've corrected it in the text.

ChemEng said...

A feature of a hedge is that is fully replaces the losses sustained. So, the insurance on a house that has burned down provides enough money to build a new house similar to the old one. Similarly, a financial hedge will recoup all of the money lost on the original investment.

As you say, with regard to climate change there are no hedges that will allow us to maintain our current way of living. A self-sufficient lifestyle has its attractions, but it is very different from the way that we live now. And, as Joe says, it will not work for our current world population. Before the industrial revolution the world population was around 1.5 billion. Now we are at 7.5 billion, and increasing.

I have found Taleb’s insights to be very valuable. But I am noticing that the term ‘Black Swan’ is becoming synonymous with ‘Bad Luck’ or ‘Unknown Unknown’, neither of which is the case. Taleb does not define a Black Swan event as being inherently unpredictable; it is just that our risk models failed to predict it, or that we ignore what the models tell us. With regard to resource depletion and climate change, we cannot predict the details or the timing, but that does not make them Black Swans.