In the investment industry, we talk a lot about risk and reward. Over time, they should be perfectly, positively correlated. The more risk you take, the more reward you should receive. The opposite is also true, less and less. While most people understand this concept as it pertains to stocks and bonds, the ‘risk reward paradigm’ also applies in real life.
Compared to many other countries, our central government has historically been relatively weak. Arguably, this has engendered a culture which prizes independence, personal control, self-help, competition, work, creativity, entrepreneurialism, initiative, and optimism. This has immeasurably benefitted our society and economy, as Americans have had to rely of themselves for success. In other words, historically, Americans have had to take, and continue to take, more risk than many other cultures.
Admittedly, I am painting a very rosy picture, with a very broad brush. However, the results largely speak for themselves, as the United States typically ranks at the top of the list, or near the top, for both entrepreneurialism and, you guessed it, stock ownership. Not surprisingly, the US controls as estimated 30% of the world’s collective wealth despite representing only 4-5% of global population.
So, I would argue the results are unambiguous: all other things being equal (which they rarely are), the more risk a society takes, the wealthier it will be. To be sure, this can lead to inequalities in wealth distribution. This is for a very simple reason: the more wealth you have, the more risk you can take.
For instance, consider Jeff Bezos, the CEO of Amazon.com. His current estimated net worth is around $199 billion. Of this, $175 billion is in one stock alone, obviously Amazon.com. As a result, this one holding represents about 88% of his net worth. By just about any definition, Mr. Bezos has an extremely undiversified and risky portfolio. However, what would happen if the value of the stock were to fall a disastrous 25%? That’s right, Mr. Bezos would still be worth around $155 billion, which is roughly the nominal GDP of Algeria. So, why not keep the foot on the gas?
While that might seem ridiculous and unfair, what is the alternative? To not allow Bezos to have so much money? At first blush, that might seem appealing to many; however, the logic falls apart pretty quickly. If Bezos is somehow disallowed the rewards of the risk he takes, intuitively, he will take less risk moving forward. How is that good for society?
It isn’t.
There are two primary ways to take risk out of a society. The first is to punish the reward. The second is to provide a reward when no risk has been taken. After all, why work for something you can get for free, am I right? However, there is something politically appealing about reducing ‘uncertainty’ in our lives isn’t there?
At the beginning of 2020, an Allison Schrager from the Manhattan Institute wrote a great column which I found on city-journal.org. The link is at the bottom of this newsletter. Here are some pertinent parts:
“Technology and globalization are changing the nature of work and commerce, displacing workers, and altering the way of life for many people. In response to this uncertain economic environment, policymakers from both parties have become preoccupied with reducing risk. But many of their risk-management proposals go too far, address the wrong sources of risk, and would undermine America’s economic leadership.
The general conception of risk management is that it serves to eliminate bad outcomes. On the plus side, risk propels economies and motivates entrepreneurs to innovate. Risk, for better and worse, is at the heart of economic growth, and successfully apportioning it—not avoiding it—is the key to prosperity. The purpose of markets is not only to match buyers and sellers and establish prices but also to allocate risk. In a functioning market, people who take the most risk can reap the biggest reward. Those who wish to avoid risk can reduce it by hedging or diversifying or by paying someone, in the form of insurance, to take on the downside risk for them…
Government can fill this void, providing some protection, so that bad luck doesn’t leave people destitute. Unemployment insurance, for instance, pools risk for workers, a certain percentage of whom are out of work at any given time, while Social Security diversifies risk across generations. The government can foster functioning financial markets, enforce property rights, and maintain rule of law to create an environment where taking risks is rewarded. But too much intervention distorts choice by encouraging people to take the wrong risks or by eliminating risk-taking altogether…
The U.S. economy gained supremacy by trusting markets to allocate risk, by letting people fail, and by rewarding those who thrived. Government has a role to play in reducing risk, but to do its job well it needs to be clear about what the most pressing risks are and how best to address them—while still rewarding risk-taking.”
I bring this up today for a reason. Whether rightly or wrongly, I believe our country is at an inflection point of sorts when it comes to how we live our lives and conduct business. On one side of the aisle, we seem to have a group of people who apparently want society to be increasingly more reliant on the Federal government for its well-being. It proposes to do so by increasing the penalty on the rewards generated from risk taking and expanding the rewards for not taking risk. These are precisely those things which reduce risk in society and, therefore, the potential return.
On the other side, we have another group of people who can’t seem to construct a decent argument why this shouldn’t happen.
Unfortunately, you can’t ignore the risk reward paradigm over time. It WILL come home to roost. The more a society relies on the government for its well-being, the less risk it will take. The less risk a society takes, the slower its economy will grow. The slower its economy grows, the less money there will be to pay for basic goods and services. The less money there is to pay for basic goods and services, the more society will rely on the government.
It is a less than virtuous circle, and one I find particularly unappealing, in aggregate, as I strongly believe a society which encourages risk taking will ultimately provide a better existence (if potentially unequal) for the vast majority. The reason is simple, the proverbial economic pie gets exponentially bigger, and even a small slice of the larger pie is better than a biggest piece of the smaller one…if you catch my drift.
In the end, our country has been a phenomenal success. This is largely due to that combination of attributes which is decidedly American. These are, again: independence, personal control, self-help, competition, work, creativity, entrepreneurialism, initiative, and optimism. These encourage risk taking and, therefore, growth. As such, and so much so, we need to be extremely wary and on guard of anyone who would say otherwise.
Take care, thank you for your continued support, and be sure to listen to our Trading Perspectives podcast.
Chief Economist
https://thegedi.org/global-entrepreneurship-and-development-index/
https://www.worldometers.info/world-population/population-by-country/
https://www.city-journal.org/risk-management
As always, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, are subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the reset of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.