In Too many lifeboats, we discussed the unintended consequences of regulation in the extraordinary context of the sinking of the Titanic but here we will do so informed by something far more day-to-day – the humble traffic light. Traffic lights are of course supposed to make roads safer for everybody but the reality is that motorists have learnt to ‘outsource’ their responsibilities to them.
They speed through ambers, brake sharply at reds and essentially pay less attention at all the world’s junctions than they otherwise would because they rely on the lights to tell them what to do. All the world’s junction, that is, until the small Dutch town of Drachten did away with all its traffic controls – and saw an almost total fall in traffic-related accidents.
With no lights, road signs and so forth, drivers had to start thinking for themselves again – slowing down, looking around and taking the appropriate course of action. Hans Monderman, who pioneered this experiment, used to like to prove its effectiveness by shutting his eyes and walking backwards into the town’s main junction. He never even got beeped by a motorist – let alone suffered the more life-threatening fate he would have done had he tried that anywhere in the UK.
The obvious moral of the story is the world becomes a safer place when people have to think for themselves. Drachten suggests this is the case with the risks associated with driving and we would argue it also holds true with the risks associated with investing, where the likes of ratings agencies, external risk measures and benchmark-relative stock weights can each play the role of traffic lights.
They all help investors to stop thinking for themselves – for example, buying an asset on the basis a third party has rated it ‘AAA’ – rather than focusing on real risk in its own sense and for their own purposes. Investors who buy an asset just because somebody tells them it is risk-free will sooner or later – as the aftermath of the credit crunch proved – run into trouble.
The interesting thing about Drachten is that, even though the new system dramatically reduced traffic-related accidents, it actually made drivers feel more nervous as they constantly had to be aware of what was going on around them.
That is as it should be. Feeling that way helped keep them – and everybody else – safe and, again, the Dracthen analogy works in the world of investment. Every time you pay for a financial asset, it is absolutely right you should feel scared that you could lose your money. That is what should lead you to analyse the risk of the asset yourself. That is your best protection.