"Risk Homeostasis - Does it Apply to Stocks at Present?"

Sydney M. Williams

Thought of the Day

“Risk Homeostasis – Does it Apply to Stocks at Present?”

June 15, 2010

Risk and stocks are inextricably intertwined. Anybody who has ever invested in stocks, bonds, commodities or any derivative thereof is aware of risk. We have all experienced our personal “Black Swan” moments. Risk is ubiquitous. The Gulf of Mexico has proven risky beyond expectations for British Petroleum. Last week we hosted a lunch for the management team of W.R. Berkley. Managing an insurance company, Bill Berkley makes his living evaluating risk. The Wall Street Journal, on Monday had two articles on the risks of municipal bonds – one article and one op-ed piece.

When I get in a cab, as I do each morning, I take a risk. Of course so does the cab driver who picks me up; while I may look harmless, he has no idea what surprises may be in store for him. Risk is everywhere.

In the investment business, we often measure risk against Treasuries – Three-month T-Bills, as longer dated ones carry the risk of inflation. Quantitative analysts measure with mathematical precision (or they claim to) risky investments versus their riskless cousins. Those of us who are quantitatively challenged try to make similar distinctions through analysis, observation and anecdotal evidence. Jim Grant, in the most recent issue of Grant’s Interest Rate Observer, for example, deems there is less risk in owning a list of thirty-two large U.S. companies than there is in Five-Year Treasuries.

A problem with risk is that it is not constant. It changes as people and conditions changes. For example, a study of taxicabs in Munich determined that the crash rate for cabs equipped with anti-lock brakes was identical to those without. The reason had to do with the fact that those using ABS took more risks, presuming the brakes would protect them, than those that did not have the new braking system. To explain this propensity to risk-adjustment, to bring risk back into the individual’s equilibrium has been called risk homeostasis by Dr. Gerald Wilde, a professor emeritus of psychology at Queen’s University in Kingston, Ontario, Canada. We compensate for changes that affect us. Going forward, weekenders in Arkansas will be more conscious of the rivers along which they camp.

One might argue that British Petroleum’s explosion in the Gulf was a result of risk homeostasis. (On the other hand it might simply have been due to a too-close relationship between BP and the Minerals Management Service of the Department of Interior – the regulatory body with responsibility for off-shore drilling activity!) Something like 30,000 deep water wells have been drilled in the Gulf. While none were in water as deep as this one, nor had any of them gone so deep into the bedrock as the Tiber Prospect, there had been no problems until April 20th. In determining risk, as drilling began, adjustments were undoubtedly made by BP engineers for the fact there had been no earlier problems – risk homeostasis was at work.

Regarding the space shuttle Challenger, which blew up over Florida on January 28, 1986, sociologist Diane Vaughn wrote in her book, The Challenger Launch Decision, “No fundamental decision was made at NASA to do evil. Rather a series of seemingly harmless decisions were made that incrementally moved the space agency toward a catastrophic outcome.” As humans, we gain comfort in our understanding of failure by placing blame. We see a similar chain of events developing in the Gulf. Whether the explosion was a product of regulatory, mechanical, or human error, or was unavoidable, the pointing of fingers seems to have superseded the search for what actually happened.

In speaking about the disastrous oil spill in the Gulf, Charles Krauthammer said, “We respond to crises because history shows us what is risky.”

But to return to stocks; as Dr. Albert Wojnilower wrote yesterday: “The tangible brighter business outlook is grossly at variance with the financial market mood.” Unfortunately, we as always, are victims of extrapolating our most recent experiences. Stocks have been a poor place to invest money over the past ten or twelve years. As investors, we appear subject to the phenomenon of risk homeostasis; we find comfort in gold, the Dollar and Treasuries, suggesting to me that the risk embedded in many stocks is overstated.