Stock talk for the main street investor.

Risk In Financials

Investing in financial stocks may seem like a low risk endeavor. For hundreds of years banks have been a relatively safe investment so it would be easy to assume this will be the case into the future.

But complexity in the financial services sector has grown exponentially over the last 10-20 years to the point where CEOs of these firms have no real way of knowing the risks their companies are exposed to. If they did understand the risks Lehman wouldn’t have failed, Merrill Lynch would still be independent and we wouldn’t be in the financial mess we’re in today.

Complex products which are relatively new to the market have created much of the mess of accounting for risk. These products are so thinly traded and hard to value that only models can be used to create an accounting value. This leads to firms valuing their balance sheets with models they’ve created themselves.

The problem with this is that a model is only as good as it’s input assumptions. Like statistics, you can make a model say anything you want. If I re-modeled all financial institutions with very conservative estimates today I could make every one of them look insolvent.

The other thing that is scary with financial institutions is the way they calculate risk. Most times assuming a daily, weekly or monthly return is somehow normalized based on previous returns. This assumption puts a 1 in 10,000,000 chance that something like the housing collapse happens. The problem is, in reality these rare events happen every 5-7 years.

So are the models wrong? I don’t know, I just don’t understand them well enough to feel comfortable with their risks. Experts with years of experience have amassed incredible losses thinking they understood the risks in financial institutions. Main Street investors shouldn’t make the same mistake.

If you do need exposure to financial stocks I would stick to conservative banks like Wells Fargo or fee based asset management firms like BlackRock (BLK) or T. Rowe Price (TROW).

Disclosure: The Mayor has no position in any stock mentioned.

Comments are closed.