The Wholly-Terrifying Risk of Non-Diversifiable Assets

Most of the ways in which we store money are diversifiable.

For example, if you store some money in the stock market, you can own a bunch of different stocks. And these days you can even own a single investment which represents, to a very close level of approximation, proportionate ownership of each and every stock in the U.S.

Today a single share of that investment would have cost you about $57.

Think of it: for $57, plus a commission of, say, $7, you could have an ownership interest in pretty much the entire American stock market. Sixty-four bucks and you own the whole shebang.

Now that's diversification: for $64 you can have an asset that is precisely as diversified as the $15 trillion U.S. stock market is diversified.

So even if something went drastically wrong with a single stock -- take, oh, I don't know . . . BP for instance, which, in a just-deserts sort of way, has lost $100 billion of its $200 billion market value since April 20th, when it, in an effort to spend $10 million less on safety measures for an especially deep well in The Gulf of Mexico, blew up a major portion of the Gulf, for an eye-opening 10,000-fold swing from money-saved to corporate-valuation-lost -- the problem with the stock still wouldn't have much impact on the value of your $57 share. That's because your $57 share reflects the entire stock market, full of thousands of stocks, so that BP represents, all-told, less than 1% of your $57 investment (the arithmetic is that the $100 billion which BP's value has fallen is two-thirds of a percent of the $15 trillion U.S. stock market).

So, all things being equal, the 50% downdraft on BP's stock would impact your $57 investment by less than 1%, or about four dimes-worth.

That's a hit you can afford to take, and that's what diverisification does for you: it translates the 50% loss suffered by BP shareholders into a 0.5% loss for you and your shares.

And, remember: before the debacle BP was among the Top 20 most valuable companies in the world, so its fall has had a far greater impact on the overall stock market than most downdrafted stocks would, so all but two or three handfuls of stocks out there, if downdrafted, would hurt your $57 investment a whole lot less.

And for those of you wondering about thinking that all we're talking about in here is idiosyncratic risk, and we're ignoring market risk, you are right: market risk is a topic for another day.

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More scarily, though, there are also ways to store your money that pretty much are non-diversifiable.

For most, real estate is the ultimate non-diversifiable asset. Because the reality is that most of us will never own more than one piece of real estate at a time. And that means that if, say, your house is in Guatemala City and it falls into a sinkhole, and if for some reason you do not have it insured against that risk, then your non-diversified risk has come home to roost, big-time. Ouch.

Or more presently, it means that, if you bought your house three years ago for 10% down, and if you find yourself now having to sell it because your job is taking you out of state, or if you lost your job and simply can't any longer afford the house , then your non-diversified risk has also come home to roost, also big-time, and also ouch.

And if you had to sell now, you would probably have to put cash into the escrow to the tune of, say, two of the downpayments you put up when you bought the house. Imagine that: putting 20% down to sell the house. Ouch.

Here's the arithmetic on where that 20% came from: figure that (a) the house cost $1 million, and that (b) the house has depreciated 25% ($250k), and that (c) you have an interest-only mortgage for 90% of the purchase price, so that (d) you owe the bank $900k, and also assume that (e) you will pay a 5% real estate commission for selling the house ($50k). In that case, you need to put $200k into escrow to sell the house, consisting of $150k to pay the bank its $900k (because you sold the house for only $750k), and another $50k to pay your broker (5% of $1 million.

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So how can a person be financially smart in the face of non-diversifiable assets like real estate?

It would be nice if we could buy derivatives that hedged the risk (i.e., you buy an investment which, theoretically, will increase in value if your house loses value, and vice versa), but all attempts at that thus far have failed, what with the DMM/UMM up/down housing twins busting at the end of last year.

I'm sorry to say, then, that, to date, the definition provides the answer: if the asset is non-diversifiable , then there's not much you can do to diversify the risk emanating from the asset, and that means that there's just not all that much you can do to smarten up the decision in terms of diversification. And that's that.

True, you can also do your best to make sure that you're not buying at the wrong time.

How to do that?

Well, there is no surefire way to do that. There just isn't. It hurts me to throw my hands up in the air and shrug, but that's the truth, and knowing that something is out of your control can be, in a way, freeing, and it definitely helps you be aware of what the risks are.

Yes, you can look at rent vs. buy charts and price trend charts, and, yes, you can call in the best economists and real estate agents, etc., but at the end of the day, I'm afraid, this is one of those situations in which you just have to hold your nose and dive into the pool, all the while praying to whatever it is to which you pray, and otherwise trying to increase your luck and alter an outcome which, sad to say, is subject to a terrifyingly non-diversifiable risk.

Instead, all you can rely on is luck: when it comes to non-diversifiable assets, you just have to be stone cold lucky.

Good luck then!

And, 'til Monday, here's to your financial health and may it continuously improve,


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I Robot, Modified: Capital Punishment for Criminal Capital

Years ago I worked at a place called Winterland. It was a merchandising company that was spun off from, as I recall, the Bill Graham concert promotion juggernaut. Winterland had started out in a venue in The Fillmore of the same name, which was where, among other things, The Band's The Last Waltz took place (and where a condo complex now stands).

Winterland sold t-shirts and other stuff with images of musicians on them, mostly in concert venues but also in stores and the like. It was a pretty nice business (other than the dealing with the musicians and their business managers part . . . ), although it did cycle through a bankruptcy reorganization in the late 90s.

Winterland is also one of the few companies that has ever pleaded guilty in a criminal court to killing someone. This came about after an employee was crushed to death in a silk-screen machine which had a safety mechanisms that someone at Winterland had disabled. Ouch.

After being brought up on criminal charges, Winterland pleaded guilty and paid a $350k fine; even though Winterland had, for all intents and purposes, killed this unfortunate person, no one went to jail. There was no eye-for-an-eye.

The lesson of that episode, at least to a jaded perspective, might be that corporations can get away with things that human beings cannot get away with -- like killing human beings.

Kinda like I Robot, but with a corporation playing the role of the robot.

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Much has been written lately about the personhood of corporations, with the trend being towards giving corporations more and more rights previously considered to be rights that only human beings should have. Nowhere, though, have I read anything about corporations, as a kind of quid pro quo, also being subject to all the penalties of the criminal law, including capital punishment.

Now this is not the place to talk about capital punishment of human beings. Those of you who know me or my writing can well guess how I feel about it. But this is the place to talk about capital punishment of corporations.

Yesterday BP's stock price fell a third, which means that the value of BP fell by tens of billions of dollars. And there is talk that BP might be the target of a hostile takeover or other buyout or a bankruptcy.

On the other hand, as people tally up BP's exposure for the oil volcano, it looks possible that BP could pay the full bill. Yup, it looks possible that BP has enough money to pay for all the damage it has caused.

I want to go on record as saying, though, that if half of what has been said about the recklessness with which BP dug this hole is true, then I think we should have a debate about applying capital punishment to the entity (leaving aside for the moment the discussion of jail for the perpetrators).

Now market-lovers will argue that the invisible hand will do its magic, and BP will be adequately punished, either through bankruptcy (Texaco did it . . .) or a buy out (Texaco did it . . . ).

But I'm thinking that that very well might not be sufficient. If BP did, as some say, overrule safety precautions, gerrymander the regulatory process and, in general, act like the biggest, baddest oil company around, and that behavior necessarily led to this calamity, then I say let's execute BP. Yes: let's use capital punishment on the worst capitalist.

Now we can all debate 'til the cows come home the wisdom of governments killing human beings who have killed; the whole eye-for-an-eye approach is a flashpoint for wedge politics. It seems to me the debate is a bit easier, though, when it comes to governments killing business entities that have killed human beings.

Here, then, let's do consider a-corporate-charter-for-an-eye, with the proceeds from the corporate carcass used to right, as well as possible, the wrongs perpetrated by the corporate perp, and the excess, if any, going to the federal government to further support whatever regulatory framework needs to be strengthened to decrease the risk of a similar occurrence.

So how would that work? I'm doing my best to write short in here, so I have to leave that topic for another day. But I do have room for the financial health tie-in, and for the fold-back.

In terms of our overall financial health, we'll all be better off when business decision-makers everywhere know that especially egregious and harmful-to-others behavior on the part of the entity risks the very existence of the entity itself (as well as the freedom of the decision-makers themselves).

Because it seems that, currently, some of them (a lot of them?) think they can get away with murder.

Until tomorrow, then, here's to your overall financial health, and may it continuously improve.
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