Thoughts on hedging

From July 10, 2009.  This is a comment relative to a post on Aleph Blog.  I held posting the comment here, so I could think this out more, but in the end I like the train of thought as it was and haven’t edited it much…

In the end, ownership is about the strategic selection of risks, calculated risks, where the likely rewards outweigh the risks. If the likely rewards don’t outweigh the risks then ownership (“investment”) is not a good choice. As Ben Graham put it, thorough analysis, security of principal and a reasonable return are the essential ingredients. Complexity bedevils analysis; hedging tends to involve concealment of risks to principal; financial intermediation (e.g. with a counterparty) requires sharing the expected return. The odds of mis-estimating risk become much higher.

On a more philosophical plane: I would hate to live in a world where everyone was “hedged” or “insured” and thought they had no risk, and yet would earn some kind of return. A world of prudent risk-takers, willing to put actual capital on the line because they’ve done their homework and willing to work to make their commitments work out, is better than a world of “hedged” risk-averse “free lunch” seekers who just want some counterparty to make everything all better for them if they turn out to be wrong.

There’s a moral hazard aspect to insurance — think about how popular the high-hazard “extreme” sports are, now that everyone feels entitled to having someone else pay for their wrecks. There’s also the problem that your average individual, regardless of means, is just not sufficiently sophisticated financially to make proper use of these “hedging” tools. We live in a nation where much of the population cannot do something as simple and obvious as paying off their credit cards in full each month! This applies all the way up to the highest levels of business and government — Representatives, Senators and even national presidential candidates are up to their eyeballs in debt that apparently is not in their financial interest. Should we really be turning the Wall Street marketing mafia loose with new “financial innovations”, on such ignorant prey?

My intuition tells me that it would be better for society if people who aren’t comfortable owning a particular asset were encouraged (“invisble hand” style) to stop owning it, NOT for them to maintain “ownership” but with “insurance”. Shiller and other advocates of hedging tools seem to be living in the pre-crash mentality, where financial complexity seemed like a good thing, and counterparty risks could be ignored. Such is not the case now. With the number of publicly filing businesses down about 1/3, and the number issuing “going concern” warnings rising dramatically, it’s flawed logic to assume that “insurance” (as a generic concept) is “guaranteed”. Would you sell a future on your home to the next AIG? The next Countrywide? The next Lehman Brothers? In the absence of financial transparency, how would you know?  Particularly with respect to off-balance-sheet (and allegedly “hedged”) risk exposures, there’s no way to tell that your counterparty of choice won’t blow up in the next 10 years (or whatever time horizon). In such an environment, hedging makes little sense from a Graham-ian investment perspective, because upon thorough analysis the risks are quite likely too high.

Comments are closed.