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OPINION

Too risky for humans

Too risky for humans
May 12, 2021
Too risky for humans

There was a note of triumphalism in the UK government’s announcement that, by the end of the year, driverless cars are coming to a motorway somewhere near you. The Department of Transport’s subtext was that puny humans should get out of the way because, as transport secretary Grant Shapps was quick to point out, humans are responsible for over 85 per cent of accidents on the UK’s roads, so the fewer such incompetents behind the wheel, the better.

True, mixed in with the Orwellian tone was grim slapstick – self-driving vehicles will be limited to speeds of up to 37 mph on motorways. This should make them really popular, especially if they adopt the default Sunday driver’s position of hogging the middle lane.

And, in the fluff of the announcement, transport minister Rachel Maclean remembered to tick the obligatory boxes. “This is a major step for the safe use of self-driving vehicles in the UK, making future journeys greener, easier and more reliable,” she said. In other words, the key selling points of robotic driving are safety and convenience and who can object to that? That’s partly the point. Who, indeed, can object to fostering safety and convenience? In a world of too much uncertainty and too little time these are the modern deities whom we all worship.

Yet there comes a moment when it is necessary to ask who is telling us this stuff and what is their motive? Take the ostensibly all-powerful need to foster safety; the one that nowadays prompts every company boss to presage a results announcement with the reassurance that “the health, safety and well-being of our employees remains our highest priority”. This is extremely relevant to investors since safety is the obverse of risk and grappling with risk – or, more specifically, putting a price on uncertainty – is the chief aim of finance and, therefore, of investing. Remember the basics – when we invest we commit our capital to the future. In effect, we say the price we have paid will, on average, compensate us for the risk of locking up money, the risk that the future will fail to deliver. So the questions arise: since today’s imperative for ‘safetyism’ is ubiquitous, surely it must affect investing too? Is that quantifiable and will safetyism benefit investors or penalise them?

Since the quantification of risk is a human construction it must be susceptible to change as our own perceptions change. What was an acceptable risk to Columbus heading west in search of new trade routes will hardly appeal to a modern-day investor in search of the returns to produce an acceptable pension income in 20 years’ time.

This is where the narrative justifying driverless cars tells us something about changing attitudes towards risk. Never mind the real motives of the unholy alliance between Silicon Valley, Wolfsburg and the developed world’s governments in pursuit of driverless motoring, the message pedalled to the driving public is all about convenience and safety. This accords neatly with our rising affluence since it is almost inevitable that as we become wealthier we also become safer. As a consequence, our perception of the diminishing risks that remain is that they are all the more intolerable. Stated as an axiom: the fear of risk rises in inverse proportion to the harm it is likely to bring.

Actually, this notion isn’t new. Go back to the 18th century and a Swiss mathematician, Daniel Bernoulli, used maths to show that an increase in wealth “will be inversely proportionate to the quantity of goods previously possessed”. In so doing – and, according to Peter Bernstein in Against the Gods, the remarkable story of Risk – Bernoulli “laid the groundwork for modern principles of investment management”. We call it the law of diminishing returns and it explains why people are risk averse, why extra wealth does not bring happiness. On the contrary, it is more likely to bring anxiety as so many rich-world neuroses of the 21st century seem to demonstrate.

The logic runs as follows (and only slightly exaggerated): since risk is abhorrent, it must be eliminated with no restraint on the amount spent pursuing that aim. However, since risk can never be fully eliminated then it is only fair citizens should be compensated for the effects of the risk they suffer or even might suffer. Since no commercial organisation will voluntarily accept such risks then it must fall to the state to act as insurer of last resort. Finally, since equity investors are citizens (directly or indirectly) then they, too, must share in this state-wide risk-elimination scheme.

We see this process – or, at least, its incipient self – in action. There was a time when central bankers considered it their core function to prevent financial markets taking on too much risk by pushing prices too high. In the famous phrase of William McChesney Martin, the longest-serving chair of the US Federal Reserve, “the job of central bankers is to take away the punch bowl just as the party gets going”. Or, at least, it was until 22 May 2013 when Ben Bernanke, then in the Fed’s top job, made the mistake of telling markets that the Fed would be taking the bowl away; specifically, it would soon stop buying in bonds, a policy it had started four years earlier to support recovery from the ‘sub-prime’ financial crisis. Markets responded by hurling toys from their prams in what became the first – and best known – ‘taper tantrum’. Bond prices fell and interest rates rose, threatening further recovery and prompting Bernanke to a quick about-turn and resumed bond purchases. In effect, he said: “Sorry, guys, that was really bad of me. You shouldn’t have to put up with all those nasty risks.”

The effect is catching. Just this month, the Fed’s present boss, Janet Yellen, had to do a Bernanke. She had made the mistake of remarking that interest rates would have “to rise somewhat to make sure our economy doesn’t overheat”. Such a statement of the obvious was too much for today’s fragile investors; or maybe they intuitively knew that by yelling they would get Yellen to do the necessary. Soon she was making soothing baby noises, assuring markets she was not recommending, or even predicting, a rise in interest rates.

What’s less clear is the effect on equity investing of the trend towards safetyism. Would it make returns lower and smoother or higher and more volatile? The argument could run both ways. If investors are shielded from risk’s worst effects, by an agency of the state, then the lows would not be so low since investors would have less reason to be fearful and less cause to sell. That also implies the highs would not be so high because investors would feel less need to tank themselves up with McChesney Martin’s metaphorical punch while the bar was open. Put more prosaically, they would not feel the need to bid prices to crazy levels.

Believe that if you will. The alternative view is that the absence of risk would only encourage investors to behave stupidly; that the moral hazard created by the presence of a rescuer of last resort would encourage investors to lose all restraint.

The chart below attempts to visualise whether either of these possibilities can be spotted in the returns from the equity markets of London and New York starting from 1900. It rests on the assumption that, if markets are reassured by a rescuer of last resort, they will be calmed, volatility will drop and the chart lines will trend down and become smoother. Alternatively, if the presence of the rescuer encourages markets to behave badly then volatility will rise. Volatility is defined as the annualised standard deviation of monthly returns and the chart lines are smoothed, in order to show the long-term trends, by using the five-year rolling average of the standard deviation.

 

 

What stands out is each nation’s most traumatic period in the past 120 years – the effect of 1929’s Wall Street Crash and the subsequent depression on the US; for the UK, the struggle between workers and bosses during the 1970s. The volatility produced by these events – crippling losses followed by hesitant but eventual recovery – overshadows all else. True, we can focus on the comparative normality of the years since 1980 thereby eliminating from the exercise these especially dramatic periods. Do that and the volatility of returns from London and New York pretty well move together, with the exception that the UK’s flirtation with European exchange-rate mechanism in the 1990s exerted a toll.

So volatility looks as alive as it has been these past 120 years without clearly becoming more excessive. Perhaps it is still too early to spot the corrupting (or calming) effects of near-guaranteed state intervention. Yet even as I write and equity markets tumble, ostensibly fearful of resurrected inflation, the question is already being asked: when and how will the authorities help out?

Investors can be forgiven if this stirs their most cynical instincts. If there is always a sugar daddy to provide the bail-out, then they must keep on buying, the riskier the better. The intuitive objection is that this offends our sense of fair play, even of justice – if people behave stupidly, they should accept the consequences.

Worse, however, this may be against investors' own interests. In Why We Drive an American writer, Matthew Crawford, uses driving, either by the agency of a human or an algorithm, as a metaphor for the creeping assault on democracy in the name of safety (hence ‘safetyism’). “The pursuit of risk reduction tends to create a society based on an unrealistically low view of human capacities,” he says. That notion already extends to esoteric parts of the securities markets where only so-called professionals can hunt. Be careful or it will extend to the greater part of the equity markets; oh and, obviously, to driving, too.

bearbull@ft.com