How Risk Aversion is Evolving

The good news: you just managed to sell your house, you got a decent price for it, and you're sensibly renting for the time being. The bad news: so now what are you meant to do with your money? It's over the $100,000 FDIC limit -- so do you divvy it up among different banks, or buy a product like CDARS to make sure it's all insured?

Maybe you open a brokerage account and invest it all in government debt: that's safe. But what if your broker goes bust? You'd probably be OK, but can you be completely sure? These are your life savings, after all. And although you could survive a small drop in their value, you would be devastated if they were to be wiped out.

What we're seeing here is a change in risk-aversion. A year ago, a risk-averse investor was one who wanted no risk of any downside, and was willing to trade higher returns to get that safety. Today, a risk-averse investor wants no risk of wipeout, and is incredibly aware of counterparty risk.

To put it another way: a year ago, risk-averse investors would have been very attracted to principal protected notes, where you pay a bank an insurance fee for guaranteeing that your investment won't fall in value. Today, risk-averse investors wouldn't trust such a product with a bargepole, since in the event the bank were to fail, they could be wiped out. Indeed, they'd probably be happier simply buying an index fund: yes, it can fall in value, but stock indices don't go to zero.

Many investors have lost so much money right now that losing a little more is no longer their biggest fear. What we need now, I think, is some way of transforming financial-sector securities so that they go from carrying a small risk of a large loss to carrying a larger risk of a small loss. If that were possible, they're looking cheap enough right now -- especially the debt instruments -- that we might actually see some substantial inflows into the sector.