Merton on Risk Homeostasis in the Capital Markets

In a new and interesting interview in MIT’s Technology Review magazine economist Robert Merton — of Long Term Capital Management fame, and, oh yes, a Nobel prizewinner — offers some musings on risk in the capital markets. He is a smart fellow, and it’s a subject he knows well, what with the sorts of adventures his LTCM took along the way toward its eventual demise.

Here, however, is Merton on whether risk is increasing or decreasing in markets as we introduce more technology, complexity, and trading velocity:

Technology Review: Is it fair to say that the current financial system is too risky?

Robert Merton: Let me give you this analogy. If you’re driving in inclement weather, you’d say that a four-wheel-drive car is safer than a two-wheel-drive car. Now suppose that we observed that over the last 15 years, the number of passenger accidents per passenger mile driven hadn’t changed at all. And someone says, Now wait a minute: Has four-wheel drive made us safer? And the answer would be, Technically, no, because we’re having just the same number of accidents we used to have. So, was this all a waste, or were we wrong? I think you know the answer, as I do. What really happened is that people get something that will unambiguously make you safer if you behave the same way you did before. That’s the key element to understand first. The amount of risk we take personally, individually, or collectively is not a physical given constant. We choose it. What happens is, we look at some new, safer instrument and we say, Yes, we could be safer doing the same thing. Or, we could take the same amount of risk and do things that were too risky to do before. So with a four-wheel-drive car, you look out the window and see six inches of snow, and you say, That’s okay: I’m going to go over and visit my family. So the question to ask is not, Are we safer? The question to ask is, Are we better off?

Interesting stuff, of course, and a restatement of what has come to be known as risk homeostasis theory. The core idea, as Merton says, is that we choose a level of risk with which we are comfortable, but that level can change with the systems in which we operate, as well as with the changing protections afforded by the overseers of said systems. The car example above is a favorite of risk homeostasis supporters.

So, is Merton right? Sort of, but the bigger story is considerably more complex. First, however, as the many critiques say, the trouble with much-promoted highway argument in risk homeostasis is that people don’t continuously adjust their behavior incrementally for every change in in-car safety systems. Sure, some people are wrongly more confident in snow because they have ABS, or possibly even because they have seatbelts, but the idea that the behavioral change is so large as to make risk constant is untrue. Matter of fact, despite claims to the contrary by the theory’s originator, Gerald Wilde, there is strong evidence (and more here) that must of the homeostasis-related driving data is contradictory, at best. Auto owners don’t actually seek out ever higher level of risk in response to safety improvements.

But the situation is very different in capital markets. In those markets, risk and return are strong related. When something becomes too easy in markets, when the real or perceived risk falls, everyone piles in, reducing returns further, and forcing traders/investors to take on even more risk — whether in the form of leverage, exotic trades, etc. — to get the same return.

And the system itself is dynamic, with reductions and increases in risk happening in response to the actions of market participants. A previously risk-free trade can become highly risky overnight, and stay that way forever, and for a week. A previously risky trade can become placid and common, as happened with some synthetics and securitization trades over the last few years. Both happen all the time, and they happen, in large part, because of a dynamic system’s response to the wild-eyed behavior of its participants.

To return to Merton’s analogy, cars don’t work the way markets do. Risk changes in the former are a step function, at best, while the latter is dynamic, regime-centric, transient, and savage. Market participants live on the risk/return frontier, a frontier can change in the most sudden and unexpected ways overnight. Give me a call the next time the local I-5 freeway here in San Diego is newly gone one morning.

Related posts:

  1. Risk Homeostasis and Soccer Headgear
  2. Human Computation in Capital Markets & Elsewhere
  3. FT to Launch Live Capital Markets Blog
  4. Do We Need a Capital Markets Safety Board?
  5. Averse to Being Risk Adverse

Comments

  1. worth says:

    Another difference is that on an icy, treacherous road, you don’t have government and other trusted officials (say, police officers) standing all along the side of the road holding signs saying “it’s ok folks! Don’t slow down at all! No danger or risk of any kind to worry about, regardless of what you’re experiencing with your own sensory and analytical apparati!” Whereas for the past year +, we’ve had plenty of governmental entities telling us exactly that in regards to the obvious financial meltdown that was underway.
    Plus, the interviewer didn’t ask him “are we safer,” he asked him if “the current financial system is too risky.” Clearly, yes.

  2. Paul Kedrosky says:

    Nicely put. I was trying to find a way to capture that encouragement aspect, but you have it about right.