Tuesday, June 26, 2007

You Don’t Know What You Don’t Know

Question: How knowledgeable do you suspect investors are with the following terms: Fat Tails, Complexity Science, Interdependency Risk, and Emergence? How familiar do you suppose investors are with phrases like “the brake becomes the accelerator”?

And how many investors are aware that “U.S. financial institutions now hold only 15 percent of total credit outstanding by the nonfarm nonfinancial sector: that is less than half the level of two decades ago. For the largest U.S. banks, credit exposures in over-the-counter derivatives is approaching the level of more traditional forms of credit exposure. Hedge funds, according to one recent survey, account for 58 percent of the volume in credit derivatives in the year to the first quarter of 2006.*”?

Investment Strategy Implications

If ever there was a case where the title of today’s blog applied, it is the state of investor knowledge regarding a transformed world, the “end of capitalism as we know it.**” Yet, many investors appear comfortable with the risk management tools of the financial engineers, and in the process have apparently bought into the idea that the social science of investing has become sufficiently exact as to resemble the physical sciences.

The problems surrounding the thus far contained crisis of credit derivatives, hedge funds, and Bear Stearns are simply a manifestation of this certainty gone awry. Yet, to get swept up in the obvious (i.e. contagion) is to fail to see the larger, more thematic, and, therefore, more significant picture.

Circumstances are far more complex than is apparent. We don’t know how deep the rabbit hole is. We don’t know what we don’t know.

*”Credit Markets Innovations and Their Implications”
Timothy Geithner
President and Chief Executive Officer, Federal Reserve Bank of New York
Vice Chairman, Federal Reserve Bank

**Tom Wolfe

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