INTEGRATED WEALTH AND RISK MANAGEMENT: FIRST PRINCIPLES

One of the ironies of the current global financial crisis is that the very innovations designed to mitigate risks in the past few decades have been blamed for causing the huge losses in wealth. But it is not the innovations that caused the cascade of losses that began in 2008; it was violations of the principles of prudent wealth management. This chapter explores two of those principles:

Principle #1: Safety First. When faced with choices involving risk, start by indentifying the safest choice and use it as a reference point for evaluating more risky choices. A risk premium can only be earned by taking genuine risk. If you choose to take risk, be prepared for the possibility that a worse outcome might occur.

Principle #2: Mark to Market. Use market prices and fair value accounting for all assets and liabilities. If an investment opportunity seems too good to be true, it is probably not true. Beware of illusory arbitrage opportunities created by use of accounting rules that violate market realities.

In the past, the U.S. financial system has been vulnerable to shocks because its accounting rules, compensation systems, and government guarantee programs have unwittingly encouraged high leverage and underfunding in too-big-to-fail financial institutions. To make the system more robust and resilient, those rules, systems, and programs have to be changed.