Sep 14, 2012

Too Much of a Good Thing

We all know the expression "Too much of a good thing", but in practice, do we act in line with this life principle ?....... NO

I'll illustrate the fallacy of this "Too Much" principle with regard to two topics: Debt and Risk.

We all know that when it comes down to setting up a new business or investing in a sustainable development, a loan may help us to start up fast and facilitate growth.

So we might say that a deliberate chosen debt (a loan) stimulates the growth of a company or investment and also stimulates the entrepreneur or investor to take the 'right' decisions.

However when adding more debt (taking up more loans) doesn't generate the intented growth, in most cases a serious profit recovery plan is needed to keep the company a life or the investment profitable.

Unfortunately this is not the way we think in saving our western economy.

We keep adding debt while the growth of our economies keeps slowing down. This development is the main reason why the price of gold keeps rising.

Golden Proof
Although in 'normal' times the relationship between gold and country debt is not substantial, it's clear that in a 'no-growth increasing-debt policy' this relationship becomes clearly visible.

Despite of these clear signs, we keep adding debt-increasing measures, while the last signs op economic growth hope drown in the sea of debt.

When I showed the above slide on a Webinar (= online seminar) , one of the participants stated that investing in gold at this (current) price level would be risky.

I answered that the opposite was in fact true, as in historical perspective the market value of the Federal Reserve's Gold has fallen back to a backing up level of around 20-30% of the balance sheet.

So in fact the Fed has allocated 'too little of a good thing ' to restore trust in the financial markets.

In other words, Gold has still a great upward potential, as seen from a risk perspective.

Without going into 'too much' detail her, in fact, it's the other way around:

The relatively high price of Gold in Dollars,
is an indicator of the default risk of the Dollar. 

Looking at the dollar from this new perspective, it suddenly seems strange that we define the default risk of a country (currency) only with help of a country's (artificial) bond interest rate (more on my Blog: Default Risk at Risk) on basis of an also artificial  'risk free interest rate'.

Why not define the risk of a country's currency in terms of it's value to a neutral 'zero credit risk'  asset class, which gold in fact is.  I challenge you to come up with a new formula for the default risk of a country, based on the price of gold (e.g. London Fix=LF)... 

Default Rate Currency X = Dc = FLondon Fix [Currency] )

where Currency=USD, GBP or EUR and F is a function which translates the actual London Fix price of Gold in a specific currency to a default risk. 

If no formula-volunteers step up, I'll come up with formula in one of my next blogs.

Now let's look from a 
 "too much of a good thing perspective" at Risk itself.
As we all know, a positive and optimistic look at life increases the probability of success in life. In examining Risk, Risk-Life is different.

When risks are far away and have not yet occurred, risk professionals as well as non-risk-professionals are inclined to underestimate risk. On the other hand, risks that occur now and then are (too) well known and overestimated. Finally unkonwn  hidden risks in the well known high frequency-low-impact risks are again often underestimated.

The Art of Judging Risk
A professional risk manager is more than a good goalkeeper in a professional football (soccer) club.

His first responsibility is to identify and assess a potential risk
 together with his (management) team.

Golden rule in this risk assessment process is to estimate risk in such a way in time that you never get into a underestimated position of a specific risk.

This implies that when we assess new risks (e.g.  'hedge fund risks' or 'country default risks') we should not start from a zero risk position and adding risk in our models while we are making progress, but rather the other way around.

This way of estimating risks will contribute to a much more professional and appreciated working method in the risk work field.

Enjoy exploring risk management. It's an everlasting activity you can't do too much!  Or can you?

Used Sources