There is no such thing as risk-free

In which I tell some stories of transforming and valuing risk — and the mistake of marking it zero, when the risk is most definitely not zero. Telling the story of Long-Term Capital Management, lifecycle mutual funds versus money market funds, and more.

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Long Term Capital Management

Investopedia article

When Russia defaulted on its debt in August 1998, LTCM was holding a significant position in Russian government bonds, known by the acronym GKO. Despite the loss of hundreds of millions of dollars per day, LTCM's computer models recommended that it hold its positions.

LTCM's highly leveraged nature, coupled with a financial crisis in Russia, led the hedge fund to sustain massive losses and be in danger of defaulting on its own loans. This made it difficult for LTCM to cut its losses in its positions. LTCM held huge positions, totaling roughly 5% of the total global fixed-income market, and had borrowed massive amounts of money to finance these leveraged trades.

Well-known book on the disaster

When Genius Failed: The Rise and Fall of Long-Term Capital Management

On September 23, 1998, the boardroom of the New York Fed was a tense place. Around the table sat the heads of every major Wall Street bank, the chairman of the New York Stock Exchange, and representatives from numerous European banks, each of whom had been summoned to discuss a highly unusual prospect: rescuing what had, until then, been the envy of them all, the extraordinarily successful bond-trading firm of Long-Term Capital Management. Roger Lowenstein's When Genius Failed is the gripping story of the Fed's unprecedented move, the incredible heights reached by LTCM, and the firm's eventual dramatic demise.

On 401(k)s and default allocations:

TIAA Institute: The Role of the Employer Default Allocation in Defined-Contribution Retirement Plan Design

Most 401(k) and 403(b) retirement plans now provide a default asset allocation for participants who do not choose their own investments. This paper offers plan providers insights on the use of defaults, including explaining why the optimal default is not a riskless allocation; why the default should reflect the characteristics of individuals most likely to use it; what attributes lead employees to select an asset allocation; and why improvement in the default allocation can reduce people’s ability to manage their retirement funds over time.

Key Insights

Modest inclusion of risky assets is beneficial for all plan participants and a more substantial inclusion is potentially beneficial for many participants.

Relatively less-experienced employees with modest funding in the employer’s account are more likely to use the default asset allocation.

Age-based target-date funds, which are used frequently as the default portfolio, may not align with particular employee preferences, such as desired retirement age.

Counterparty credit risk (from One Minute Economics):

Equitable Life UK

Equitable Life UK Timeline of Events from the BBC

Richard Roberts: Did anyone learn anything from the Equitable Life? Lessons and learning from financial crises

The traditional with-profits life assurance policy was a highly opaque and complex product devised and managed by the industry’s high priests – the actuaries. At Equitable, the non-executive directors were incapable of following their mathematical convolutions and thus of effectively monitoring or controlling the leading executives who, boy and man, were actuaries. Thus they failed to spot the over-allocation of bonus and over-payment on claims, which put Equitable towards the top of the league tables but critically weakened its financial position.

Complex and opaque financial products proliferated in the years before the financial crisis. Devised by bank ‘rocket scientists’, their structured products, such as credit default swaps, surpassed the comprehension of not only many directors but also of banks’ risk models and, so it would appear, regular professional scepticism. ‘Where were the people that said, “hold on, that is not right”?’ wondered a senior banker. ‘Where were all the academic and mathematical departments? The risk analysts? The rating agencies? Where were the regulators? All those – stuffed full of very bright people – why did none of them say: “Hang on a second”? I genuinely cannot say why of all the people in the world who do this sort of stuff – the modelling and the reasoning – why there wasn’t even a 10 per cent proportion who cast theoretical doubt on it?’