One Major Mistake That Puts Your Pension at Risk

December 2 2014

Your pension is being invested according to an outdated academic theory. Even though in 1998 the theory was proven blatantly false, financial regulators continued to use it as a center piece of regulatory policy. For instance, an entire financial industry was build in the Netherlands based on the guidelines set by the AFM (Netherlands Authority for Financial Markets), despite the fact that th

One Major Mistake That Puts Your Pension at Risk

Your pension is being invested according to an outdated academic theory. Even though in 1998 the theory was proven blatantly false, financial regulators continued to use it as a center piece of regulatory policy. For instance, an entire financial industry was build in the Netherlands based on the guidelines set by the AFM (Netherlands Authority for Financial Markets), despite the fact that they are based on an academic mistake that was refuted years ago, both in theory and practice.

What does this mean for you?

A financial storm can ruin your pension. Just like renowned hedge fund Long-Term Capital Management went down in 1999, can your pension evaporate into thin air.

The Failure of Financial Regulators

The AFM, the Dutch financial regulator, defines risk as “volatility.” According to the AFM, the more an asset price fluctuates, the higher its risk.

Obviously, the AFM, nor any other financial regulator, came up with this definition by itself.

This academic definition was popularized by mathematical economists who wanted to make economics a “quantitative”  science. They wanted to mimic the achievements of natural sciences by treating human beings like atoms. If risk is defined as “historical volatility,” risk suddenly becomes measurable, comparable to how you would measure the freefall of an object in physics.

How the AFM Shaped the Dutch Financial Industry

The AFM has forced this definition of risk systematically onto the entire financial industry. It has been the foundation of study curricula, license requirements, prospectuses, and investment allocation decisions that financial advisors and asset managers make.

A financial advisor is not allowed to perform his job without a permit by the AFM, which it only grants when he or she fulfills its requirements. Any critics are excluded. The result is that the vast majority of people is misled into believing that the AFM can know how risky an investment is.

Risk Cannot Be Measured! How AFM’s “Risk Measurement” is Putting Dutch Pensions at Risk

In its “Risk Meter” (The AFM believes risk is measurable!), a little man is shown that suffers from a heavy burden. This representation is used when the investment was “volatile” during an arbitrarily chosen period. However, when an investment is “little volatile”, the little man walks upright:

AFM.gif

Interestingly, a government bond which yielded a steady 1% for the past ten years, but then shows a loss of principal, is not volatile in statistical terms. Nevertheless, most of the money is gone. So, is this definition of “risk” sound?

The Deathly Blow to “Risk=Volatility”

In 1994,  Long-Term Capital Management (LTCM) was founded. At its foundation lies the idea that risk equals volatility and can therefore be measured.

LTCM was different from any other investment fund. Its office looked like an academic conference. There were lectures, followed by dry academic discussions.

The fund employed the “smartest guys in the room.” All of LTCM’s partners were academic big shots, with the team consisting of PhDs and Nobel laureates. Myron Scholes and Robert Merton — who created the famous, but naive Black-Scholes option model — were among the team members. It was the investment community’s ivory tower. Other investors were considered inferior.

This “dream team” was envied. They thought their pseudo-scientific risk analyses were flawless. Their precision had an aura of infallibility. It was the era of financial engineering. Everything was measurable. The world could be captured in a bell curve. LTCM even reported once that the likelihood of a 20% loss equaled 0.1%.

The End of Long-Term Capital Management

Not only were they fully convinced of their own qualities, but they were also able to persuade bankers to provide generous amounts of credit. With billions of dollars borrowed, they thought they could arbitrage away small price discrepancies in markets. In 1997, when a financial panic hit the markets, the fund’s equity declined rapidly. With its leverage, the “academic” idea of mathematical risk management proved fatal.

In 1998, the Federal Reserve intervened. It provided a bailout to LTCM because U.S. banks lent billions to the fund that now was bankrupt. It was one of the Fed’s most controversial episodes in its history.

LTCM’s fatal flaw was the very same definition of risk now used by the AFM.

Flawed Definition of Risk May Cost You Your Pension

Risk equals historical volatility, says the AFM. Risk can therefore be measured and is an inherent property of an investment or investment class. An investment is risky when it’s volatile.

But volatility is not what counts. What really matters is the probability of you losing money. A share, bond or commodity is not inherently more or less risky. A share of ExxonMobil may be very risky in some circumstances and less risky in others. This depends, among other things, mostly on the price at which the share is bought.

The current argument is: stocks and bonds have a certain inherent risk, regardless of their price. This is a very odd way of reasoning. According to this argument, the risk of an investment in the S&P 500 at 2,000 points is equally risky as an investment in the S&P at 1,000 points. Or that the risk of a 30-year government bond with a 0.5% interest rate, is equal to the risk of a 30-year government bond with a 10% interest rate.

Pension funds invest heavily in stocks and bonds. Currently, pension funds have a third of their assets invested in stocks. But they do not take into account that current stock valuations show clear indications of a bubble. Let’s suppose stock prices decline with 40%, then pension funds would see their equity suddenly decline by 12%. And those pension funds are already facing solvency issues, despite record high stock prices.

The same goes for bonds. Interest rates can hardly fall any further. And in case interest rates would rise, pension funds will incur enormous paper losses on their bond holdings. However, according to financial regulators, no one is to be blamed, because they were invested at all times in the “less risky” asset classes.

Is Gold Risky?

An investment in gold is not necessarily risky or safe. Current prices are low. Relatively low, given the increasing amount of Western sovereign debt and stagnating economic growth. Buying gold is currently far less risky than it was in 2011 when the price of gold was around $1,900 dollars per ounce. Sovereign debt levels are higher, structural problems have worsened and the price of gold is down by over one third.

In the past weeks, the price of gold had some trouble breaking through the $1,200 barrier. For the short run, this is a sign of weakness. With the Swiss gold referendum of past Sunday, it might be possible that the price of gold drop to $1,100 per ounce.

With that said, given current prices, gold remains very attractive as a long-term investment. I advise long-term investors not to speculate on even lower prices of gold.

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