Risk comes in two basic flavors in the realm of finance: the expected and the unexpected. There’s no obvious fix for the latter, other than remembering that a black swan can fly into your financial life without warning. That implies some basic preparation, like keeping a stash of cash. Expected risks, in theory, may be easier to grapple with. Single-security risk, for instance, is easily minimized with diversification. But other expected risks can be more problematic, as we’re reminded in a new paper that surveys financial crises over the centuries. Indeed, a recurring risk can be a tricky adversary if its reappearance schedule unfurls in s-l-o-w motion, in which case it’s easy to dismiss/ignore the threat potential as nonexistent.
“Major default episodes are typically spaced some years (or decades) apart, creating an illusion that ‘this time is different’ among policymakers and investors,” advises “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” a working paper by professors Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard).
The central message: the relative macroeconomic calm of the past generation isn’t necessarily written in stone. It’s easy to think otherwise, of course. So it goes for cycles that unfold over long stretches. Lulling otherwise prudent investors into a false sense of security is as old as markets, and so it should surprise no one that many look to the recent past and extrapolate that as fact for the future.
Readers of these digital pages know that your editor has a warm spot for studying cycles and looking for the historical perspective, such as our post back in 2006 that considered a research paper looking at the history of 20th century economic booms. Perspective is a valuable thing, or so we believe. But it can be akin to watching grass grow if you’re wondering what to do now, this minute. No, historical perspective won’t help much for day trading, but maybe, just maybe, the long view promotes a healthy respect for risk. And that respect may one day save your financial life.