Rethinking investment risk
Financial innovation is supposed to reduce risk — in theory, at least. Yes, new financial instruments based on the housing market helped cause the financial crisis of 2008. But in the abstract, those same instruments have the potential to spread risk more evenly throughout the marketplace by making it possible to trade debt more extensively, rather than having it concentrated in a relatively few hands.Now a paper published by MIT economist Alp Simsek makes the case that even in theory, financial innovation does not lower portfolio risk. Instead, it raises portfolio risks by creating situations in which parties sit on opposing sides of deep disagreements about the value of certain investments.“In a world in which investors have different views, new securities won’t necessarily reduce risks,” says Simsek, an assistant professor in MIT’s Department of Economics. “People bet on their views. And betting is inherently a risk-increasing activity.”In a paper published...