My latest column is up online (it’s in the paper magazine that comes out tomorrow). Here’s how it begins:
A share of stock-or a bond, a house, a stand of timber or any other asset-is worth the following: the future income one hopes to receive from it minus a haircut for the risk that things won’t turn out as expected.
This definition makes risk crucial to setting and understanding prices in financial markets. But we humans aren’t so great at gauging risk. We pay too much heed to the recent past. We obsess over gruesome possible outcomes while ignoring the mundane but dangerous. And we often cannot envision what will happen next.
If you’re looking for an explanation of the wild behavior of financial markets in recent days, this failure to get a grip on risk is as good a one as any. Many analysts attributed the mini-panic that began in Shanghai to a sudden change in investor “risk appetite.” But why now? What suddenly made everybody see the future as riskier? Read more.
Loyal readers will notice similarities between the column and a Tuesday blog post. They are not coincidental.
In related news, econoblogger Felix Salmon has a smart post today pointing out that the Shanghai composite index suffered just as big a drop back in late January and early February as it has so far this week–it just didn’t happen to lose 8.8% in a single day:
The problem is that because of the news cycle, things which happen quickly are more newsworthy than more important things which happen slowly. So a big fall in the stock market over the course of one day makes front pages around the world–and if you’re going to make a big deal out of why the stock market fell, then you’re going to have to come up with some kind of reason for it.
Yes, it is true: Journalists and their deadlines are the root of all that is wrong with this world. Actually, I think sharp one-day market drops are significant, because they both reflect and alter investors’ ever-changing perceptions about risk. But that doesn’t mean they’re explicable.