Thursday, July 26, 2012

Disaster Economics - When pessimism is too optimistic

Interesting data from Robert Barro of Harvard University.  If you define the word "disaster" as a 10% decline in national gross domestic product per capita - - we had 58 disasters in the 20th century.  But crucially, only two of these occurred between 1950 and 2000.

Your average mutual fund manager or wealth management advisor has lived in a world without disaster risk.  If you flip open Bodie's Investments book, the word disaster is not in the subject index.  Chapters like "Risk Aversion and Capital Allocation to Risky Assets" and "Introduction to Risk, Return, and Historical Record" assume a fairly stable world.  A world of risk and reward.  Not a world of disaster risk and reward.

The world of low-disaster risk might be coming to an end.  Hopefully we will not be in for a nasty regression to the mean where we get 58 disasters in a very short period of time.  If we do, it all starts looking like another Christopher Nolan movie.

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