The 5 Ds of Financial Risk
Of the four main types of risk management, I’m least knowledgeable about financial, which has the goal of protecting large fortunes from losses. (The other main types of risk management are traditional, i.e. insurance-based, which was the essence of my job at UC Berkeley; enterprise, which addresses risks that might prevent an organization from reaching its goals; and existential, which seeks to assure humanity’s survival.) Despite my lack of interest, and despite qualms about its ethics, I think financial risk management bears minding on occasion, particularly when its heaviest hitters make big pronouncements. So I read through Goldman Sachs’ Summer 2022 grand statement on global financial risk, Inflection Points, which may be downloaded here. (Thanks to International Intrigue for alerting me to the report.)
Keeping in mind that financial risk management is about protecting portfolios, with only incidental regard for the general welfare (profits over people — that’s my ethical qualm), Inflection Points’ bottom line is that the investment climate is changing even more rapidly than the actual climate, and markets face long-term disruptions “likely to have profound effects on the world economy.” There are five such disruptions, all of them starting with the letter D. Several are inflationary, so if you think a couple more interest rate hikes by the Federal Reserve and a swift end to the Russia-Ukraine war will get us back to two percent annual inflation, think again.
- Deglobalization. Concerns over national security, lack of opportunity for blue-collar workers, and vulnerable supply chains are pushing many countries, including the US, to rein in the virtually unrestricted cross-border flow of capital, goods, expertise, and people that’s been the norm since the 1980s.
- Digitization. Pandemic-related innovations like remote work and telemedicine are here to stay and will spread to other areas of the economy, offsetting to a degree the higher costs associated with deglobalization.
- Decarbonization. Forty years too late but better late than never, humankind has begun moving from fossil fuels to sustainable energy sources. The transition will be inflationary and take decades, but the alternative is collective suicide.
- Destabilization. The political order established after the fall of the Soviet Union in 1991 is giving way to one in which liberal democracies, including the US, most of Europe, most Commonwealth countries, and parts of east Asia, align against authoritarian regimes. This is bound to cause often-unanticipated commodity shortages and price shocks, a current example being the surge in wheat costs due to the Russia-Ukraine war.
- Demographics. As Baby Boomers and Gen-Xers die off and Millennials and Gen-Zers replace them, changes in living patterns will doom some businesses (will fountain pens even be a thing after King Charles goes?) and invigorate others.
From its financial risk perspective, Goldman Sachs recommends active portfolio management to navigate these shifting financial realities. But looking at the 5 Ds more broadly — from an existential risk perspective — only destabilization seems to present genuine risk. Deglobalization, digitization, and decarbonization are rational responses to existing problems; they have their drawbacks, but over the long haul will likely increase the quality of life for most people. And changing demographics are inevitable. So while the one percenters ponder what proportion of their wealth to invest in lithium mines and treasury bills, the rest of us need to figure out how we’re going to cope with persistent inflation while the global economy makes necessary changes.
That is, assuming the wonks at Goldman Sachs are correct. The cynical traditional risk manager in me believes no one can predict the future, Black Swans are real, and two years from now Goldman Sachs will publish a different analysis, although the fix — active portfolio management — will be the same.