Hedging Risk with Leverage

For the last several decades, the investing community has been ruled by a paradoxical notion that investors can hedge their risk by taking a leveraged position. This view is paradoxical because the derivatives used in leveraging were designed to amplify risk.

There are some isolated cases where the hedging strategy works; however, when implemented on a wide scale, this method of taking a leveraged position to hedge risk simply creates a systemic risk and sets up the market for failure.

Classical and Modern thought have a fundamentally different approach to paradox. Thinkers of the Aristotelian tradition sought to avoid paradox. Modern thinkers, from Hegel to Bertrand Russell, made paradoxical thinking central to their world view.

I believe that ideas matter. The ideas from the classical era produced science, the US Constitution, the free market, and prosperity.

The paradox ridden dialectical view keeps creating systems that fail. It has produced communism, fascism, Nazism and a score of radicalized ideologies.

I irk Libertarians in that I draw a sharp distinction between the free market and capitalism. I support the free market, but believe that the modern dialectical view of the market taught in schools (capitalism) belongs in the same scrap heap with all of the other paradox ridden theories of the modern era.

Last week, President Obama made a stir by comparing AIG executives to suicide bombers. I think there is merit to his statement. A suicide bomber holds the paradoxical belief that doing a great evil will bring on a greater good. The AIG derivative department believed that they could hedge risk by taking a leveraged position.

Obama is content to lay blame on a character defect of the AIG executives. I take my thinking one step further and realize that both the suicide bomber and AIG derivative investor learned their snide little world view in a school.

The effects of education are easy to see. Warren Buffet studied investment ages ago when the classical liberal worldview held sway. He learned a system called value investing which was driven by a desire to weigh and measure the values of different investments. Not only did Warren Buffet do well in his career, a fairly large number of people saw an improvement in their lives along with Buffet.

The modern investor, the people who've given us a steady stream of market bubbles and crashes, learned their world view in schools where Marxian thought holds sway under the moniker of modern liberalism or progressivism. The classical liberals and their quaint views about value have been driven out of the picture for shiny new equations and computer models based on material dialectics.

Maurice J. Dupr&ecute; has an interesting article discussing the Mathematical Seeds of the Economic Collapse in which he criticizes the idea that one could simply take Einstein's equations from the study of Brownian motion and build an investing strategy on it. Such a model starts with the hubristic assumption: "Let's assume people are nothing but specs of pollen.")

This question of the source of or woes is extremely important. If our woes are the result of the greed of few bad apples who mucked up the works, then the solution is aggressively enforced regulation. If the problem is our view of the market, then the new regulatory regime does nothing but set us up for the next round of failure. (This was the point I was trying to make in hubris v. greed.

In conclusion, the paradoxical idea that a society can hedge risk by aggressively leveraging investments proved to be as unstable as all of the paradox ridden system of the Hegelian/Marxian tradition. If we wished to return to an age of prosperity, we need to develop a world view that reason and logic over paradox.