The era of "stocks for the long run" has given way to a warning posted on the doors of the stock exchange, Bruce I. Jacobs writes, or so he envisions: "Abandon all hope, ye who enter here."
Mr. Jacobs, principal of Jacobs Levy Equity Management Inc., Florham, Park, N.J., writing in the January/February issue of Financial Analysts Journal, said: "Risk, dormant through much of the 1990s, has been rediscovered, and there is no shortage of experts willing to share their wisdom on how to stomp it out."
However, the "desire for risk avoidance can lead to the development of investment products that, while intended to reduce risk, can actually increase the volatility and fragility of financial markets as a whole," he wrote.
An array of insurance-like products or strategies seeks to control systematic, or market, risk. Insuring against systematic risk differs from traditional insurance, which protects against a specific risk, he noted.
As such market insurance activity grows, it will "exacerbate market moves, increasing volatility," which "may further increase the demand for insurance against downside moves," thus generating more hedging-type activity, he asserted.
Investors who buy insurance against a stock market decline shift the risk onto the insurance provider, which tries to use instruments such as options and trading strategies like option replication to shift the risk to another party. But that shift is dependent on finding willing counterparties, according to Mr. Jacobs. "And as the demand for insurance increases, it tends to exhaust the supply of counterparties," he wrote.
"Who then becomes the risk bearer of last resort?" he asked. "It may be the taxpayer," i.e., the government, or investors in general, "who must bear the risk in the form of the substantial declines in prices that are required to enticerisk bearers back into the market. Ironically, products designed to reduce financial risk can end up creating even more risk."