Why is risk so extremely important to understand today?       

Today's markets are not the markets of the 60's, the 20's or 1800's. The sophistication of our markets today has taken risk to a much greater level than any previous generation. Ironically, with our advances in technology, massive infrastructure, and academic studies, we have come to the conclusion that our markets have gotten safer. Look back in time with me and ask yourself, "Are we really safer now than in the past?"

Consider that when the National Banking Act was established in 1864, real estate loans were prohibited. Consumers could not even get credit through a bank or standard lending institution.  As a nation, we could exchange our paper currency for gold coins at our local bank. Due to the fact that banks went under and there was no branch of government to bail them out, people were much more cautious with where they placed their deposits. The majority of investors, more comfortable with a set time to get their money back with interest, invested in bonds, if at all. As for stocks, these investments were only for the  most speculative investors. Most did not follow an index, and there was no such thing as buying a basket of securities that represented one.

We all know of the massive changes that have occurred in our world over the last 140 years, opening up capital markets to millions of investors. While this has lead us to the highest standard of living ever recorded in history, it has also brought about a great deal of risk. Today, credit is easy to attain. Not only is real estate lending not prohibited, it is the largest area of our financial institutions' lending. Consumers are bombarded with credit cards, lines of credit, no interest payment plans, and home equity loans in order to purchase whatever their hearts' desire. The auto industry rarely expects cash down payments. Debt continues to expand more and more.

As for the markets, individuals and institutions must invest in stocks, if only to keep ahead of the effects of inflation. In most "conservative" portfolios, bonds have a smaller allocation than stocks. There are dozens of indices, representing everything one can thing of. The vast majority of trading volume on the exchanges comes not from the purchases and sales of individual companies, but from trading baskets of stocks representing an index. We trade trillions of dollars a year in derivatives, paper instruments that do not even represent any particular company's or government's productivity. Our banks are backed by the promise that, should there be poor management of the bank's assets, government insurance will protect the investor. It escapes our notice that these types of bailouts create disincentives to prudence and lead to numerous crises such as the Savings and Loan Crisis of the late 80's, the bankruptcy debacle of Orange County and the meltdown of Long Term Capital Management in the 90's, and the recent collapse of Enron and the structural problems that are just now coming to light on Fannie Mae.

So what does this have to do with the institutional and retail investor today? A lot. With credit swelling to historic levels in both consumer and government areas, the questions every investor should be asking are, "What effects will this have on the financial markets as both governments and consumers are forced to start reducing their debts? Will this  debt overhang cause a slowdown in the economy? Are there assets that have been inflated in price (based on credit) that will lose buyers once that amount of credit starts contracting? Will that loss of buyers have a downward impact on prices in various markets?"

While I know these issues are painful to address, time is of the essence. Study reveals that market level risk changes. Today, risks are high in the area of stocks, bonds, and real estate, making this an asset allocator's worst nightmare. Markets do not follow some clean pie chart or generic description of risk. Men make decisions. If they are prudent decisions, then there are benefits. If they are reckless decisions, we must eventually face the consequences.

Do not be naive. Risk is not only at the individual or portfolio level. All investment strategies must consider systemic risks as part of ongoing due diligence. If not, that portfolio stands a high chance of failure.