When Smart Investors Do Stupid Thingshttp://www.fool.com/investing/general/2013/05/14/when-smart-investors-do-stupid-things.aspx Morgan Housel
May 14, 2013
In his 2003 memoir, former Treasury Secretary Robert Rubin wrote:
This is smart, but depressingly ironic. While writing the book, Rubin was chairman of the executive committee at Citigroup (NYSE: C). Five years later, while still under Rubin's watch, the bank added its name to the list of firms who went broke (or close to it) by failing to focus on remote risks.
I remembered this story this weekend when reading a blog post from economist Noah Smith, one of the sharper commentators out there. Smith was discussing hedge fund returns (or lack thereof), and wrote:
Pardon me, but I disagree.
The problem here is the definition of "risk." As defined in finance textbooks, including the Sharpe ratio Smith mentions, risk is volatility.
But volatility is a strange way to think about risk. Time and time again, investments utterly implode after periods of silky-smooth calmness.
Take Rubin's Citigroup. Before it blew up, it has a long record of stable, consistent profits:
Or consider AIG (NYSE: AIG). Before it blew its top in 2008, the insurer enjoyed two decades of smooth, predictable, volatility-free profits:
In each case, equating volatility with risk would have sweet-talked you into a dangerous sense of complacency. The narrative, which is common among large companies, probably went like this: AIG earns stable profits year after year. That makes it a safe, low-risk investment. Maybe even safe enough to leverage up on.
And then ... boom! Investors lost almost everything overnight.
To be fair, Smith was