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Why does everybody start talking about systemic risk, after a crisis has already started? If we define a systemic risk event as something large enough to affect the entire global financial and economic system, then you would think that the best time for investors to be told about these terrible events is before they occur. But that's not the way it works now. The way it works now is that the large institutions which are in the business of managing our money charge us handsomely for advice that often describes dangerous events to us only after the bulk of their effects have been felt. Then all the discussion is focused on whether it is over or not, and if not, how bad it will get.
Why?
Is it because they're not smart enough to see things coming? Not according to them. Several months ago I was on the phone with the managers of a very, very large international bond fund. They wanted me to support the recommendation of the staff of an investment committee, on which I sit, to put a lot of money under their care. Their performance had been poor lately, but as a long-term investor, I didn’t hold that against them. I wanted to know how they thought, especially about risk.
But no matter what question I asked them about their way of thinking they always seemed to give an answer in terms of the intelligence, resume, or academic qualifications of their analysts. So and so studied under Barry Eichengreen at UCLA; this guy has been analyzing bonds for X years; this other guy has lived in South America analyzing bonds for his whole career, etc. Well that's nice. Smart is better than dumb, but right is better than smart, and right is largely a matter of fundamental principles.
After two or three iterations, I finally was able to talk to one of the fund’s super-star analysts, and we talked about risk in Europe. Greece, he told me, was actually not as risky as some of the other peripheral countries we had discussed. Why? Because their political instability risk factor is based partly on income inequality and Greece's income inequality had been dropping. But why, I asked, did Greece have more income equality than they previously had? Because their economy was in a tailspin and economic contraction almost always affects people at the top more than people at the bottom. And people at the bottom, the analyst told me, did not sink very much during the recession because Greece has a very large social welfare system.
So, according to MegaFirm, economic meltdowns and large scale government dependency reduce risk? Other countries, the analyst told me, used churches and non-profit organizations to care for their poor, which was not as reliable as government aid in ensuring income equality. I thought about the founder of this fund, who has long since passed away, even though the firm still bears his name. I grieved for what I know he would have thought about this materialistic, truncated and stagnant view of man, given his own life-long emphasis on human economic freedom and spiritual development. I concluded that the firms poor performance was not an anomaly, and voted to block the recommendation that we invest a large sum of money with them, which by the grace of God helped to protect the portfolio from this manager's even greater underperformance subsequently.
The problem is that for many large firms, systemic risk is a matter of exogenous events, sort of like comets which originate outside the normal operations of the solar system, suddenly appearing, flashing across the sky and then disappearing. But I think that risk is frequently more a factor of the character of a nation: that risk is often 'earned'. Each mistake, not recognized and corrected, becomes a precedent. Policy mistakes reinforce trends, and increase risk. Each expression of political vice, government dependency, excess spending and debt, twisting of the rule of law, class war demagoguery, rots the foundation of society and adds a layer of risk.
Lung cancer is a systemic risk to a human body, but a smart insurer will not wait to change the premium until the first black spot appears on the X-ray; he will accrue risk with each cigarette smoked. Investors should do the same thing, charging greater premiums when there is greater foolishness, and not wait for the tell-tale fleck of blood on the handkerchief.
There is a quote from Margaret Thatcher that has begun to recirculate with the recent premiere of her biopic, “The Iron Lady”:
Watch your thoughts for they become words. Watch your words for they become actions. Watch your actions for they become...habits. Watch your habits, for they become your character. And watch your character, for it becomes your destiny! What we think we become. My father always said that...
It's really a paraphrase of something attributed to various authors including Charles Reade and Ralph Waldo Emerson:
Sow a thought, and you reap an act; Sow an act, and you reap a habit; Sow a habit, and you reap a character; Sow a character, and you reap a destiny
This is good personal advice, the sort of thing you put on plaques or quote in commencement speeches. But I'm saying it's also the kind of thing you put in valuation models. Because 'what we have done, and what we have left undone, in thought, word, and deed' on a national level determines as much as anything else the margin of safety that a prudent investor should require to invest in that nation.
In fact, this principle matters more than almost everything that passes for risk management in the oak paneled halls of the gigantic stewards of America's wealth. And it only adds insult to injury that the long deceased men whose names are still on the walls of the firms, in their day knew better. Risk is not ‘event-driven’; risk is character-driven. Events are not the cause, events are the effect of our national character.
