Risk Is Not a Four-Letter Word

While central bankers, small business owners, and stock market analysts rarely agree on much of anything, all appear to acknowledge that too much risk fueled the subprime mortgage bubble that led to the worst financial crisis since the Great Depression. The consensus view appears to be fairly simple and straightforward: risk is bad.

Certainly, foolish and excessive risk-taking can lead to financial catastrophe. But is all risk bad?

While excessive risk can indeed be dangerous, eliminating risk in any investing scenario is neither possible nor even beneficial. In the space of a few years, we have seemingly gone from a period in which no risk was too big, to a period in which no risk is too small. Fortunately or unfortunately, risk can never be truly eliminated, and in fact, an appropriate tolerance for risk is essential for meaningful economic growth.

Risk Will Always Be With Us

Since many more things could happen than will ever actually happen, some level of uncertainty will always exist. No matter how much care is taken in making any decision, a negative or unintended outcome is always a possibility. In short, risk will always be with us. Uncertainty may equate to risk, but that does not mean risk must always lead to danger.

As Peter Bernstein noted in his book Against the Gods: The Remarkable Story of Risk, the history of the modern world is marked by a "tension between those who assert that the best decisions are based on quantifications and those who base their decisions on more subjective degrees of belief about the uncertain future." So while proposals for financial and corporate governance reform strive to eliminate all risk, we need to ask whether artificial limits on all "risk" may actually create the greatest risk of all.

Consider for a moment a world in which the tolerance for risk is zero, or at least one in which perceived risk is heavily penalized. In a risk-intolerant environment, markets would require enormous returns on equity investments and significantly higher interest rates on debt for all but the safest "blue chip" borrowers. In such an environment, few new businesses would ever be started, funding of research and development would disappear for all but a handful of projects, and business development would slow to a trickle. Growth would simply be priced out of the market.

Since businesses today operate in a 24/7 global economy, it must be understood that "black swans" in obscure corners of the world could lead to unexpected, and possibly negative, consequences from Wall Street to Main Street. If excessive risk can be appropriately reduced, it is more likely than not that risk will lead to economic growth than it will to danger.

Prudent Risk: An Oxymoron?

Risk is the fuel that feeds growth and the spark that permits creativity to flourish. But the acceptance of risk need not be synonymous with the acceptance of recklessness. So how do we avoid recklessness, without penalizing prudent risk-taking?

First and foremost, rewards must be tied to the risks being taken. Reward without risk is neither fair nor rational. The best, and perhaps most painful, recent example of imbalances that can result from risk/reward decoupling is the subprime mortgage crisis. The ability to pass along the risks to others is at the core of what created the subprime mortgage crisis. Mortgage brokers earned commissions by writing mortgages that were promptly resold, effectively decoupling the reward of the commission from the traditional risk of the mortgage holder: that interest and principal payments would be made on a timely basis until the loan was paid in full. Mortgage brokers were rewarded by writing mortgages, but they had no stake in whether those mortgages were ever repaid.

The logic that underpinned these mortgages was simple and seemingly incontrovertible: Home prices will always rise, so no matter what the price of the home sale or the terms of the mortgage, the transaction would be riskless. Ironically, one of the biggest hazards in modern financial history was created by millions of these "riskless" transactions, because at least in part, the risks were decoupled from the rewards at a crucial step in the chain.

Second, risk takers should be expected to act with discretion and intelligence, taking into account all the known facts and the relevant circumstances. When acting on behalf of others, a risk taker should be expected to act in the same manner as that person would with his or her own business or personal finances. The so-called prudent person rule is a long-established legal principle that has served us well. Risk takers, entrepreneurs, and inventors all create enormous wealth for the broader economy; their risk-taking should not be punished so long as they are being prudent. When investors and lenders finance these visionaries, particularly with other people's money, they must be expected to exercise discretion and due diligence and to dampen any unrealistic expectations that such entrepreneurs and inventors may have.

A Vital Ingredient of Growth

If we seek to eliminate risk, who will create the next Microsoft or Google? If we punish risk takers, will anyone invest in the next microchip or cellular technology? Or fund development of the next Lipitor or Celebrex? If governments will not support risk, how will the next Internet ever be created? Avoidance of excessive risk may well be necessary, but any attempt to eliminate risk would be the greatest risk of all.

Risk is an essential ingredient of economic growth. As legislators, regulators, and central bankers consider the causes of the financial crisis and ways to prevent the next one, it will be vital that they recognize that risk will always be with us and, in fact, that appropriate risk is a necessary evil. To paraphrase one of the silver screen's legendary investors, Gordon Gekko, "risk is good."