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Dominant risks

| Posted by: Paul Donovan | Tags: Paul Donovan Weekly

  • Markets are supposed to balance risk and reward. The problem is that humans are not very good at seeing risk.
  • Humans use storytelling to share ideas. Very often one version of a story will become dominant. It does not matter whether the version of the story is true. If the story is about a really bad event, everyone will know the story. Economists call this a "dominant narrative."
  • A dominant narrative may make investors misprice risk. The most dramatic economic event of modern times was the 2008 financial credit crunch. Everyone "knows" that greed, spending, and too much debt led to the crisis. The story tends to add that debt is sinful. (A very similar story exists for the 1920s).
  • This story shapes investors' fears today. Investors focus, perhaps too much, on debt levels. Everyone "knows" debt was (in the story) the sinful cause of everything that went wrong in 2008. Thus, debt today must be a risk. But debt today is different from debt ten years ago. There is more government but less private debt. The new risks for investors do not get the attention they should. The story of today's risks is not properly being told.