Externalities Abound (Risk Complexity, too)

This morning, I want to address the issue of externalities, and managing risk in an era of ever-increasing complexities.

Equity investors deal with a variety of risks: Earnings, Business Cycles, Execution, and Valuation. These are the traditional risks that are, for want of a better word, ordinary. Whether you want to call them typical or usual or normal, they are the standard factors that make stock selection a fun challenge, and separate good companies (and their equities) from lesser investments.

Beyond those challenges, markets must also confront “Externalities.” These are the risks that come from outside of the normal business cycle: War, Credit Crisis, Oil Shocks, Terrorism, Weather, Earthquakes.

Note that investors have always had to deal with these — they have pre-dated markets, currently co-exist with them, and will eventually outlive them. Externalities are a part of life, and you can neither plan for them nor ignore them.

Consider the Cold War: During the 1950s, ’60s, ’70s and ’80s, the threat of nuclear conflagration between the USSR and the USA was the geopolitical backdrop.  Yet 3 of 4 of those decades saw very good market returns. Threats of extraordinary, extra business cycle events did not derail equity returns, though a good argument can be made that post detente, global markets screamed higher  (contra: that was a 30 year period of falling rates).

It is important for investors to understand these externalities. Every day, headlines such as this — ‘Funding Crisis’ averted for Italy, Spain cross the tape. They are a part of the global backdrop. They cannot be ignored, but they should not be obsessed over.

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There is one element of these externalities that should be analyzed, focused upon, even obsessed over: The current challenging complexities are entirely man-made. No, the European banking crisis is not a Tsunami, not an earthquake, not a drought. Along the same lines of analysis, the US credit crisis, housing collapse, and Great Recession were not a meteor falling from the sky, but instead were entirely foreseeable and preventable. They were brought on by a radical recklessness that was ignored for years, until pretending it didn’t exist simply became impossible.

In the US, the Smash & Grab was the world’s greatest reallocation of wealth — first from shareholders to corporate insiders, than then from taxpayers to insolvent Banks. Note that this wealth transfer was not from the poor to the rich, but rather, from the middle and upper middle classes to the Über-rich. The political implications are very, very different.

Risk complexity abounds . . . Investors better get used to it.