THE
BEAR'S LAIR 'Risk free' goes out the
window By Martin Hutchinson
The potential downgrade to AA in the US
credit rating has exposed one massive fallacy of
modern finance: there is no such thing as
"risk-free" investment. Much of the modern finance
canon will need to be re-written, or better still,
scrapped altogether. However, this discovery has
considerable implications even for those of us who
adhere to more rational investment philosophies.
Risk-free investing is central to modern
financial theory. The Capital Assets Pricing
Model, which postulates an optimal "frontier" of
investment possibilities, assumes that frontier is
reached by a judicious mixture of risky
investments and risk-free investments or leverage.
The Black-Scholes options valuation model
assumes the options
can be hedged by buying or
selling the underlying security, borrowing or
investing the proceeds at the risk-free investment
rate. Modern risk management assumes that some
assets are without risk, so that the Basel system
of capital regulations rates government securities
of Organization for Economic Cooperation and
Development governments at zero in their capital
adequacy calculations.
The Efficient
Market Hypothesis and the Modigliani-Miller
Theorem don't depend on the ability to borrow and
lend risk-free, but even if those shaky pillars of
the modern finance edifice still stand (though
undermined by other considerations) the threat by
Standard & Poor's to downgrade the United
States' credit rating has nevertheless wrought
considerable theoretical havoc.
Over long
periods of time, the ability to reinvest annual
returns risk-free is simply not there. The 18th
century calculation of Richard Price showing that
a penny invested at the birth of Christ would have
grown by Price's time to an immense golden ball,
was fallacious. There had been no continuous
society other than China in which such an
investment could even theoretically have been made
and even in China the proceeds' value would have
been destroyed by the inflation of the Mongol
period.
Even in more modern times, the
calculation that the Native Americans who sold
Manhattan for $24 in 1626 could have kept more or
less even with the buyers by the simple expedient
of investing the proceeds at 6% compound interest,
to get $149 billion today, falls down by the fact
that no safe 6% investment, compounding over
nearly 400 years, has been available.
Even
though the Dutch government has been a
satisfactory credit risk over the period, and
yields fairly close to 6% were available on Dutch
government paper in 1626, there has been no way to
reinvest the money safely and get a 6% return for
most of the intervening 400 years.
The 197
years of the gold standard, from Sir Isaac
Newton's establishment of it in 1717 until its
abandonment in 1914, saw interest rates no higher
than 3% for almost all of the period. $100
invested at 6% for 197 years gets you $9.67
million; the same sum invested at 3% gets you only
$33,800 - nowhere near enough for our unfortunate
Native American sellers to have kept up with
rising Manhattan real estate prices.
In
the 20th century, smug proponents of equity
investment have shown that the US stock market
brought an average annual real return of around 7%
over the century as a whole. But suppose in 1900
you had invested in the German stock market, the
Austro-Hungarian stock market or the Russian stock
market. In all three you would have lost all your
money at some point in the century, thus being
prevented from achieving a satisfactory return by
the end of it.
Indeed, the losses were
large enough and prevalent enough that even an
investor who, like Keynes' infinitely
sophisticated Edwardian consumer, tracked down
1900's emerging markets and diversified fully
would have achieved a lousy return - for one
thing, the truly greatest economic success stories
of the 20th century, such as Korea and Saudi
Arabia, were completely un-investible in 1900.
If you had told your 1900 investor of
these difficulties, he would have smiled in a
superior manner and suggested a truly risk-free
investment - in Consols, maybe with a few US
Treasuries mixed in for good measure - and he
would have been killed by inflation, even if he
had avoided adding German government bonds to the
mix.
In 1991, it would have appeared
completely clear how safety could be achieved - by
buying US Treasuries, maybe with a mix of common
stocks to guard against inflation. Needless to
say, as a long-term investment, that looks much
less reliable today. Today's safety-conscious
investor would probably go for a spectrum of
emerging markets investments, in the hope that
21st century economic growth would provide
commensurate returns.
They would very
likely be disappointed. None of the much-vaunted
BRIC economies, for example, can be said to be
decently run. Brazil is a democracy, but with an
oversized state written into its constitution and
an electorate that has gone for a series of dozy
socialists (who have been blessed by a massive
rise in commodity prices, but that won't last
forever). Russia has gone from hopelessly corrupt
to malignantly corrupt to mildly benignly corrupt
- and looks likely to revert to malignantly
corrupt again next year if Vladimir Putin returns
to the presidency. India is a democracy, but with
an electorate that persistently re-elects a party
whose mainstream reflects the most foolish
features of 1930s Fabian socialism - and
unexpectedly rejects the only government that had
produced genuine reform, that of Atal Bihari
Vajpayee in 1998-2004.
A year ago, China
might have been thought an exception to this
generalization. Even for those of us who don't
share the Tom Friedman view that "China is
awesome", it had appeared - on the economic front
at least - to have discovered some secrets that
had eluded others. Like the Japanese governments
of 1955-90, the system might not bear close
inspection from either a democratic or free-market
viewpoint, but it appeared to work.
Evidence in the past few months is
increasingly showing that China's approach is less
successful than it appears, and that international
investors' ability to profit from China's success
is highly problematical. The Chinese banking
system once again seems to be teetering on the
brink of collapse under the weight of its bad
debts. The Chinese rail disaster late last month
indicates that, while Chinese infrastructure
investment is blessedly free from the appalling
cost bloat of equivalent US investment, it is
nevertheless subject to a very high degree of
corruption. China's high-speed rail network
appears to have little more in the way of safety
features than the Cabinet-Minister-slaughtering
George Stephenson's Rocket of the 1830 Rainhill
Trials. 180 years of safety advances appear to
have been ignored by China in the rush to build
the government's prestige investment.
Finally the succession of accounting
scandals in China's small-cap public companies
demonstrates that overseas investors in Chinese
companies have no effective means of ensuring
their rights are protected. Only the overpriced
behemoths with serious government links or a
reflection on China's international prestige may
be safe - and being overpriced, they are unsound
investments anyway.
The pessimists' answer
is to put the lot in gold, maybe with a mild
diversion of resources to oil, silver, copper and
platinum. While in the short term these look an
excellent bet, I am not in the long run a "gold
bug", even though I believe that a gold standard
would be much more satisfactory than the current
monetary arrangements.
Consideration of
price changes since the stable pre-1914 gold
parity of 3 pounds, 17 shillings and 10 pence an
ounce suggest that a price today of around 400
pounds or $650 represents an appropriate
equilibrium. Even accounting for the rise in
global population and wealth since 1914, it is
difficult to justify an equilibrium gold price
above $1,000 an ounce. Consideration of mining
costs, around $400-500 per ounce for the major
operators, suggests a similar equilibrium price
level, even with a gold standard.
Of
course, based on 1980's speculative peak, peak
gold prices of $2,500 or even $5,000 are
justifiable, but those would be short-term and
unstable maxima, to be followed by a lengthy and
punishing bear market such as occurred in
1980-2000. Thus even gold, at today's prices is by
no means a risk-free investment. Supply/demand
considerations suggest that with the economic
growth in emerging markets $100 oil may appear
cheap in a few years, but oil is a difficult and
expensive commodity to hold, and the major oil
companies are subject to substantial political
risk.
Thus even the supposedly "defensive"
investments of commodities and energy are by no
means risk-free at current prices when long-term
considerations are taken into account.
It's not surprising that "risk-free"
investments do not abound today; the world has
been subjected to a 15-year period of money
creation during which assets of all kinds have
been driven up to unsustainable prices. Not only
are the tenets of modern finance nonsense in these
markets, but the tenets of traditional finance
also offer little hope for the investor anxious to
preserve his capital. About all that is feasible
is to put money in a diversified portfolio where
the losses over the next few years will be smaller
than in the market in general.
That may
appear a very un-ambitious and pessimistic goal,
but what do you expect from a Bear?
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-11 David W Tice &
Associates.)
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