Why Is Financial Risk Like a Forest Fire?

A little risk is better than none

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May 09, 2019
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When is risk good? That is a tricky question. Most investors want to their risk to be as low as possible, while retaining opportunities to win. But on a macro level, a certain amount of risk is both healthy and required in order to support a functioning investing environment. By artificially suppressing minor risks, we invite the possibility of much larger problems developing.

This is a lesson known well by those who manage forest fires. If you put out every small fire that develops, you deprive the ecosystem of its natural mechanism for clearing out dead trees and brush. If excess amounts of dry wood are allowed to accumulate, the next fire will have catastrophic effects.

The same is true of markets. If investors believe there are no risks on the horizon, they will collectively act recklessly in a way that creates truly bad effects. This is the logic of a recent research note from Morgan Stanley (

MS, Financial), which sees the recent uncertainty around the U.S.-China trade deal as a good thing in the long run.

“It’s been a foregone conclusion for over a month that a deal was coming, we just didn’t have all the details and timing remained a little uncertain. This assumption is now being called into question and markets have to quickly reprice... 2019 has been one of the strongest starts in history for equity markets around the world. There have also been very few pullbacks or corrections to speak of, something that’s also unusual. There are many reasons for why investors are experiencing such good times this year, starting with a Fed that has been much more accommodative than last year. Hope for a trade deal with China has also been part of the risk-on cocktail.”

Amid this risk-on environment, investors have generally been afraid of missing out on what seem like easy returns even though underlying earnings growth and economic data appear to be a little weak. The stall in the trade deal has knocked down these excessive expectations somewhat, which will hopefully restore more sober thinking to the markets. The note goes on to identify the Federal Reserve’s recent behavior as another catalyst:

“There is also the Fed who told us last week that they are not going to do a pre-emptive interest rate cut as insurance against low inflation or growth. They will wait for the data to tell them they need to act. Both of these events essentially re-introduced two-way risk again to markets that have been on a one-way ride this year. Whenever markets get this one-sided it pays to fade it a little, and the one-two combo of trade risk and a less dovish Fed may be the catalyst to remind folks of this fact.

Our advice remains the same: equity markets are ahead of the fundamentals at this point, and we think that a 10% correction is overdue and necessary for a more healthy long-term outcome, ie. for the secular bull market to continue. Two-way risk may not feel good in the near-term, but it’s a more normal and sustainable outcome.”

In other words, the return of risk may not feel like a good thing, but in the long run we will all be better off for it. Better a small forest fire than a blazing inferno.

Disclosure: The author owns no stocks mentioned.

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