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As yet another banking scandal unfolds with JPMorgan Chase's $2 billion hedge fund loss, it provides a reminder to take a look at your own investing style. How safe are your investments, and do you understand your level of financial risk?
JPMorgan has some explaining to do about this so-called synthetic credit that catapulted its losses, but there's an argument to be made that for all the shock displayed at corporate overleveraging by the people in charge, history repeats itself all too often. Look at what happened in 1996 when Long-Term Capital Management's highly leveraged hedge fund bet the wrong way on Russia and lost $4.6 billion, requiring a bailout from the Federal Reserve. Or we could revisit Enron, which hid enormous amounts of debt internally, leading to $11 billion in shareholder losses and the collapse of the Arthur Andersen accounting firm.
It goes without saying that institutions aren't learning a lesson here, but what can investors take away from this? No matter what it's called, risk means you could lose money. Period. Brett Arends aptly makes the point in an article in The Wall Street Journal: Traders call it volatility or beta, but individual investors should think of it as the possibility of a loss. Leverage only means the stakes are much bigger. There is no bailout for individual investors, and when a bet goes bad, you're the only one on the hook to pay up.
It's true that a portfolio that includes some risk will lead to gains in a way that safer fixed-income investments won't. Some experts suggest individual investors take a page from university pension funds, such as Wharton and Harvard, which invest in hedging strategies to further diversify and increase gains. But who understands the types of alternative investments JPMorgan and other institutions were creating and marketing? And why make a risky investment even more so by leveraging? Lesson No. 2, after making sure you understand risk, is ensuring you have a thorough understanding of the type of investments you're getting into, without letting high-flying returns cloud your judgment.
What do you think about the JPMorgan Chase debacle?
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