Acton Commentary

Why Risk Matters

On February 27, 2007, share-prices throughout the world took a tumble. “Grey Tuesday”, as it was quickly called, began with China's main stock-market taking an 8.8 percent fall.

Heavy selling almost immediately commenced on the New York Stock Exchange, resulting in the disappearance of all gains and more since the beginning of 2007. Wall Street endured its deepest one-day fall in equities since 2001. Shares in some of America's largest investment banks experienced their biggest losses in a year.

What began as a Chinese cough before developing into an American cold quickly become a mild flu for the rest of the world, with European and emerging markets in Asia and Latin America all plunging. In recent days, the markets have rebounded, although analysts are quick to point out that investors have a ways to go before fully recovering from last month's slide.

The job of financial commentators is to explain to the uninitiated what happened, and there was no shortage of articles analyzing these events. Some stressed that the Chinese sell-off began following false rumors of imminent government action against “speculators”. Others observed that the flow-on effects underline just how significant China has become in the world economy. Still others suggested that the real reason for the sell-off was investors being spooked by evidence of a softening American economy.

Whatever their specific diagnosis, almost every commentator mentioned that a major contributing factor was investors fleeing risky investments, especially those where asset-prices had reached unsustainably high levels. The safe haven of government bonds benefited immensely from this suddenly risk-adverse climate. Central bankers referred to a healthy “flushing out” of unsustainable risk in the market.

Reckless risk-taking in finance is as irresponsible as reckless risk-taking in politics and family life. Yet in the midst of a financial slow-down, it is all the more necessary to remind ourselves why risk-taking is so important in market economies.

First, risk-taking is indispensable for wealth-creation. At the root of wealth-creation is entrepreneurship, and entrepreneurship is impossible unless we are ready to risk testing new ideas, products, and services in the market-place. It is a given that most new enterprises in free economies fail. This underlines how much we all rely upon people being willing to take risks, be it entrepreneurs starting new businesses, banks extending credit, or financiers investing in venture-capital schemes.

Second, prudential risk-taking allows for prudential speculation. Though the term “speculation” usually has negative connotations, we should remember that everyone is a speculator in the market-place. As the economist Ludwig von Mises noted, everyone in the market-place acts in light of uncertain knowledge. It is simply impossible for anyone to know everything about the future.

Hence the small farmer who speculates that wheat rather than rice will yield a greater financial return in the near future is no different from the private banker who speculates that equities rather than bonds will be a more profitable investment over the next year. Moreover, if their speculation is reasonable and informed by facts and experience, it will likely lend stability and predictability to economic trends, thereby reducing the prevailing degree of uncertainty.

Again, however, sound speculation depends upon willingness to risk acting without full knowledge of all pertinent information. Without this risk-taking, the level of speculation in an economy drops and a corresponding increase in economic uncertainty follows.

Lastly, risk-taking counts because it contributes powerfully to the moral justification for people retaining ownership of the profits they earn. The great medieval theologian Thomas Aquinas was one of the first to stress this point. Those willing to risk the expenditure of their capital, time, or labor in an enterprise, Aquinas argued, enjoyed a claim over the fruits that non-risk takers in that activity did not share.

All of this assumes, of course, that institutions that protect and promote prudent risk-taking are in place. While there is no such thing as a risk-free environment, we can create a financial atmosphere that is risk-friendly. People will not take entrepreneurial or speculative risks if their endeavours are not protected from arbitrary interference, if they are not guaranteed stable ownership of the capital put at risk, or if the bulk of the proceeds are sequestered from them.

In other words, firm adherence to rule of law, strong property-rights protections, and a low-tax regime are indispensable if prudent risk-taking is to be nurtured and rewarded. So too is a financial environment that facilitates risk-diversification, so that the cost of failed risks are absorbed with as little pain as possible by the stock market, banks, and an array of financial institutions.

Above all, risk matters because it reminds us that business and markets are ultimately the outcome of human reason, choice, faith, and hope. To think, choose, and hope is risky. But the risk-free life is no life at all.