What is "Too Much Risk," Anyway?

8/28/2012 05:32:00 PM
During the recession, we all heard about excessive risk taking by financial firms, and investors. Let's take a step back and think about what we are complaining about here.

There are two types of risk: diversifiable and non-diversifiable. The former is risk that results from exposure to a specific asset like, say, subprime mortgages. Firms can completely eliminate diversifiable risk by having a portfolio of assets such that losses to some of the assets will be offset by gains to others. But there is also non-diversifiable risk, which is better known as the business cycle. This is the type of risk that cannot be eliminated by changing the relative proportions of your investments in different assets.

It makes little sense to complain about diversifiable risks in a macroeconomic contexts. If the manager of the hedge fund you invested in left you exposed to more diversifiable risk than you would have prefered, then go yell at your specific hedge fund manager. But by the very definition of diversifiable risk, it makes no sense to complain about hedge fund managers in the aggregate--this type of risk simply doesn't exist in the aggregate.

That means that we must be complaining that somehow all these investors caused the business cycle by taking too much non-diversifiable risk. But what is "too much?" Even supposing that risk taking has anything to do with the business cycle (in most macro models, it does not), there is no threshold below which the business cycle completely disappears. That means that this all comes down to a matter of preferences--how much wealth are we willing to give up in order to reduce the volatility in our consumption?

Now, you may think that the degree of volatility we have witnessed was disproportionate to the amount of benefit you have received from these risky investments. Fair enough, but that is just a personal preference. At the point where the "excessive risk" argument conceids that this is all a matter of preferences, we are admitting that the outcome can't really be improved on. The fact that the risks were taken proves that they are consistent with the aggregate preferences of the public, the very same public whose aggregate preferences determine which policies we enact to regulate risk taking.

I hope that, going forward, we can drop the rhetoric about risk taking. It is really a distraction that obscures the real issues behind what happens in financial bubbles.