The Bezzle and the Central Banks
In The Great Crash of 1929, John Kenneth Galbraith describes the bezzle, the “inventory of undiscovered embezzlements,” that grows in times of rising markets. When the markets collapse, these schemes are exposed and lead to large losses for investors. But Galbraith identified a sweet spot after the embezzlements have been committed and before they are found out:
“Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.)”
The bezzle of the current bull market isn’t stocked with Ponzi schemes and outright frauds in my view. Rather it is built on the notion that risky assets have become practically risk-free thanks to central bank policies.
Ever since central banks cut interest rates close to zero, investors have been told to stretch for yield and take on more risk in their portfolios. First, there was TINA (“there is no alternative” to stocks). Then came the hunt for yield in fixed income and the use of low-volatility and high-dividend stocks as substitutes for bonds. No wonder low-volatility stocks have outperformed the global equity market over the last decade.
MSCI World vs. HFR Low Vol Risk Premium Index
“The biggest risk is not taking any risk.”
Which is not the smartest thing anyone ever said. The thing with risk is that taking it is necessary, but taking it means we can fail if the risk materializes. Thus, some risks are not worth taking because they will lead to catastrophe.
That Mark Zuckerberg can get away with quotes like this is simply a reflection of survivorship bias. Plenty of entrepreneurs have taken risks and failed. We just tend not to hear from them afterwards.
And over the last decade, investors have felt compelled to pile on more risk. A few years ago, a family office client of mine asked me to optimize their portfolio. For historical reasons, one third of the portfolio was invested in property, one third in a single stock — the company of the founder — and one third in liquid assets. Because the family office was based in Switzerland, it faced negative yields for most government bonds. So, what could we do?
We couldn’t add property or stock market investments because of the already-highly concentrated positions. In fact, the client had to choose between taking on duration, credit, or foreign exchange risk — or some combination of them — in fixed-income investments.
It wasn’t a nice situation, but in the end, the family office opted for the credit and duration risk combo. This has worked out well. So far. But just because risks haven’t materialized doesn’t mean they are not there.
And thanks to the ample liquidity provided by the central banks, we have all enjoyed a blissful state of increased “psychic wealth” over the last few years.
But in the face of a recession, some of these risks will come back to bite us and the bezzle will shrink or collapse. As someone once said:
“Giving liquidity to a banker is like giving a barrel of beer to a drunk. You know exactly what is going to happen. You just don’t know which wall he is going to choose.”
We will find out which wall. Whatever one it is, my guess is that credit and equity market risks will play a role.
But my guess is as good as anyone’s.
What we have to do today is take a look at the risks that are buried in our portfolios. The first half of 2019 was very calm, which is the best time to prepare for a bumpy ride ahead. So if volatile times are coming, we need to check our portfolios and make sure we are only taking risks that we can live with.
And if we aren’t comfortable with some risks, we need to reduce or hedge them. And this is where government bonds — even at negative yields — can be helpful. Because they do provide a level of safety that is hard to come by in other asset classes. And if holding low-yielding government bonds, cash, or other safe assets at these rates makes no sense to you, I recommend reading the fourth rule of my series The Virtuous Investor. I describe a technique for looking at portfolios to understand the role safe assets play in them.
This will hopefully help us better better manage risk so that when the next bezzle is discovered and all the associated psychic wealth vanishes, our clients’ portfolios, and our own, will still be able to achieve their financial goals.
For more from Joachim Klement, CFA, don’t miss Risk Profiling and Tolerance: Insights for the Private Wealth Manager, from the CFA Institute Research Foundation, and sign up for his regular commentary at Klement on Investing.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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