'Rethinking Investment Risk'

A new paper in the QJE shows that financial innovation raises portfolio risks:

Rethinking investment risk, by Peter Dizikes, MIT News: Financial innovation is supposed to reduce risk -- in theory, at least. Yes, new financial instruments based on the housing market helped cause the financial crisis of 2008. But in the abstract, those same instruments have the potential to spread risk more evenly throughout the marketplace by making it possible to trade debt more extensively, rather than having it concentrated in a relatively few hands.

Now a paper published by MIT economist Alp Simsek makes the case that even in theory, financial innovation does not lower portfolio risk. Instead, it raises portfolio risks by creating situations in which parties sit on opposing sides of deep disagreements about the value of certain investments.

"In a world in which investors have different views, new securities won't necessarily reduce risks," says Simsek, an assistant professor in MIT's Department of Economics. "People bet on their views. And betting is inherently a risk-increasing activity."

In a paper published this month in the Quarterly Journal of Economics, titled "Speculation and Risk Sharing with New Financial Assets," Simsek details why he thinks this is the case. The risk in portfolios, he argues, needs to be divided into two categories: the kind of risk that is simply inherent in any real-world investment, and a second type he calls "speculative variance," which applies precisely to new financial instruments designed to generate bets based on opposing worldviews.

To be clear, Simsek notes, financial innovation may have other benefits -- it may spread information around world markets, for instance -- but it is not going to lead to lower risks for investors as a whole.

"Financial innovation might be good for other reasons, but this general kind of belief that it reduces the risks in the economy is not right," Simsek says. "And I want people to realize that." ...

[There's quite a bit more explanation in the original post.]