History is the Vital Starting Point for Sound Risk Management

In an opinion piece published in The Washington Post yesterday, the newspaper’s columnist Robert J. Samuelson decried economists’ lack of attention to history. He wrote:

By and large, most economists don't care much about history. Introductory college textbooks spend little, if any, time exploring business cycles of the 19th century. The emphasis is on "principles of economics" (the title of many basic texts), as if most endure forever. Economists focused on constructing elegant, mathematical models…

But often, the models' assumptions depart so radically from reality that the conclusions become useless. Someone who studies history becomes humble in the face of the ceaseless changes and capricious mixing of motives.

In the context of the recent housing bubble that collapsed in the middle of 2006, and produced a severe credit crunch, banking crisis, and sharp synchronized recessions in many parts of the world in its wake, Samuelson’s piece is an important work. What happened is not a novel event. It has been a recurring theme in the long narrative of financial and economic history. So long as human nature remains relatively constant, it will remain a recurring theme.

In general, the rise of asset bubbles—whether in stocks, commodities, or real estate—results from a confluence of human nature, innovation, and easy credit. Even as the specific attributes of various bubbles differ, the pattern of events in which bubbles rise and then collapse is a familiar one. Rationalizations of a “new era” in which advanced technology, management breakthroughs, or sophisticated quantitative models have somehow tamed the business cycle and rendered asset price crashes largely extinct are little more than delusions. In fact, such explanations are a telling symptom that the kind of euphoria that feeds an unsustainable asset price boom has infected market psychology. In such an environment optimism runs wild, blinding investors, lenders, and borrowers to marketplace risk.

In the opening of Benjamin Graham's and David Dodd’s classic work Security Analysis, Graham and Dodd wrote the following of the 1927-33 period that witnessed the U.S. stock market crash and, in its aftermath, the Great Depression:

It can hardly be said that the past six years have taught us anything about speculation that was not known before. Even though the last bull and bear markets have been unexampled in recent history as regards both magnitude and duration, at bottom the experience of speculators was no different from that in all previous market cycles… That enormous profits should have turned into still more colossal losses, that new theories should have been developed and later discredited, that unlimited optimism should have been succeeded by the deepest despair are all in strict accord with age-old tradition.

Three principles found in Graham’s and Dodd’s seminal book are particularly relevant today.

• Principle 1: “Investment is by nature not an exact science.”

The idea that financial engineering could yield precise mathematical models that would all but eliminate risk and/or ensure attractive returns on investment is little more than folly. Models are representations. They are simplifications of highly complex phenomena. They do not adequately capture the role of human behavior. Their underlying assumptions do not give sufficient weight to episodes of irrationality. As a result, they cannot provide anything close to prescience, even if they provide an illusion of safety from risk.

• Principle 2: "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants."

The efficient markets theory notwithstanding, the historical record demonstrates that asset prices do not always remain anchored to fundamentals. Asymmetric information, among other factors, can lead to significant pricing issues. History also reveals that the departure of asset prices from underlying fundamentals can be both substantial and prolonged.

• Principle 3: "…if past experience is any guide, the current critical attitude of the investor is not likely to persist; and in the next period of prosperity and plethora of funds for security purchases, the public will once again exhibit its ingrained tendency to forgive, and particularly to forget, the sins committed against it in the past."

This tendency to forget, or in Graham’s words “forgive,” is regular feature of human nature. Lessons from the past, standards of risk management, and a general sense of prudence all erode during booms. Euphoria entices borrowers, lenders, and investors to push the frontiers of risk in an aggressive pursuit of the last dollar of marginal profits. The scramble for market share trumps discretion. When easy credit is added to the herd-like rush for marginal profits, a full-blown asset bubble can rapidly materialize.

In an especially prescient piece written in December 2004, Morgan Stanley's chief economist Stephen Roach explained:

Nearly five years after the bursting of the equity bubble, America has done it again. This time, it is the housing bubble. But this speculative excess may be the cruelest bubble of all—and has already led to a sharp compression of national saving, a record current account deficit and an ominous overhang of personal indebtedness. The U.S. was fortunate in avoiding the perils of a post-bubble carnage in 2000-2001. It may not be so lucky this time...

While it is only a few years since the bursting of the equity bubble, memories of that speculative excess have already dimmed…

In sum, effective risk management requires a strong understanding of the historical record, market structure and evolution of that structure over time. A firm grasp of the historical record is a necessary starting point for building such an analytical framework. Without it, risk management cannot be effective.

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