On Risk-Taking

Just to throw an idea out there, you hear all the time that the financial crisis was caused by excessive risk-taking. And clearly there’s something to that. But on another level, it looks to me kind of like excessive risk-aversion. If you look at something like venture capital that doesn’t have this kind of blow-up, it’s not that they’re not taking risks. On the contrary, venture capital investments are very risky. The point is that the venture capitalist is consciously accepting risk. He understands that an investment in a start-up could easily go bust and that a lot is riding on the shrewdness of the people evaluating the substantive merits of the investment. You can hedge your bets to some extent, but clearly you can’t make the risk go away. And that’s the whole point. If you “win,” by getting in on the ground floor of the next Google or Microsoft or Apple you could make a ton of money. Or you could make a much more modest sum. Or you could lose everything. It’s just inherent to the enterprise.

The issue on Wall Street, as best I understand it, is that people convinced themselves that the risk inherent in investing could all be engineered away. That you could create a situation where you didn’t really need to evaluate the underlying soundness of the investments and didn’t need to accept that investing is an inherently risky enterprise. Instead, thanks to the engineering, you could get big returns with total security.

However you want to characterize it, this was wrong. But I think it’s better to characterize it as too much effort being put into a futile risk-eradication campaign rather than too little. If you just accept that investing is risky, then you focus your energy on trying to identify sound investments with risks you’re willing to accept. What happened instead was a kind of willful denial of risk.