Editor’s note: This article was first published in January 2012; it was written during the euro debt crisis, and the remark that markets were behaving in a way that was anything but normal refers to that period.
The fundamental principle of Murphy’s law: “Anything that can go wrong will go wrong.” Keep this in mind whenever you put your money into any kind of variable-income bank product. We don’t know exactly how many complaints a bank receives every day from customers who feel they’ve been swindled. Still, with a bank there’s no swindle as such, just the big mistake of not reading, or not knowing how to read, the small print of the product we’re being offered.
The banks’ latest masterpiece is investment funds that use a risk-control system based on VaR (Value at Risk). These funds look very appealing when the bank presents them to us. Here’s an example of how our money can vanish without our having any way to make a claim.
Imagine we’re offered an investment fund with a 95% VaR, with a return of 11% and a maximum loss of 3%. It’s a fund for a moderate investor: the investment isn’t safe, but the risk doesn’t seem very high. That’s when the customer asks the bank’s “salesperson”:
Could you explain that a bit more? Does it mean I have a 95% chance of earning 11% and only a 5% chance of losing 3% of my money?
So the man from the bank explains it again:
A 95% VaR on this fund means that the maximum expected loss is 3% at a 95% confidence level.
Put that way, it seems clear that we have a 95% chance of not losing money, or at least of not losing more than the stated loss (3%). But… nothing could be further from the truth with this type of fund, because with a bank we must keep Murphy’s law in mind: if there’s a 5% chance that something will go wrong, then 95% of the time that 5% is exactly the outcome we’ll get (unless you’re a private banking client).
Once you realize you’ve lost all or a large part of your capital, you go to find out what happened, since the bank clearly hasn’t delivered. And that’s when the bank explains the reality of what you signed — in other words, what it never told you clearly but which, lo and behold, was right there in the small print, written in technical language that few people understand or have the time or inclination to read:
“A maximum expected loss of 3% is set at a 95% confidence level. The maximum expected loss with a 95% probability would therefore be that 3%. However, 5% of the time this loss could exceed 3%, since this product estimates the expected loss that could be incurred under normal market conditions.”
If the market has been through turbulence, we’re no longer under normal market conditions, so the fund’s managers are free to act as they see fit and save their own skins, even if that means inflicting a bigger loss than estimated on the fund’s investors.
Let’s be clear: the market today is behaving in a way that is anything but normal, so there’s no better investment fund than the one we can build ourselves by spreading our capital across several products or securities.
If it’s any consolation, a book written not long ago explained that a blindfolded monkey throwing darts at stock listings had picked far more winners than the banks’ investment analysts.
That’s why, if you put your money in someone else’s hands and there’s a 1% chance of losing, always remember the blindfolded monkey throwing darts and Murphy’s law, because you’re almost certainly in that 1%.
Further reading
Featured image: friggy_30, CC BY 2.0, via Wikimedia Commons.
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