The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium...
The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.
This summation awaits an elegant statement of the solution. Felix offers one:
Financial complexity and innovation, on this view, are essentially tools of obfuscation. And it's easy to hide risks when risk-averse investors want debt-like products which retain their face value: such instruments tend to have very low volatility, and so look and feel as though they're low-risk, even if they're full to bursting with enormous amounts of tail risk. The answer, as I've said many times in the past, is for risk-averse investors to be willing to take a small amount of explicit market risk, and to move towards safe equities (utilities and the like) and away from debt. Because if they go to an investment bank asking for safety, they're likely to just get hidden risk in return.
But aren't a lot of the most risk averse investors funds or insurance companies with limits on the kinds of assets they can invest in? I'm not sure we can fix this problem without knowing the answer to the question we've been asking for a year now: why did the ratings agencies underestimate the tail risk, and is that reason fixable?
why did the ratings agencies underestimate the tail risk, and is that reason fixable?
The same understimating of risk also resulted in Japan's lost decade. Banks assumed that loans backed by real estate were 100% safe - that turned out to be false.
Going forward I coudl see us getting into a commodity bubble with loans being back by gold or oil. Banks would loan billions to expand mines and oil platforms safe in the knowledge that oil or gold would never go back to $30/barrel $300/oz.
The fact of the matter is that when an investor ("sophisticated" or not) outsources their due diligence to the Ratings Agencies or research analysts, they have no one to blame but themselves when performance varies from their expectations.
I'm not sure why Felix (and so many others) presume that individual (and even some "sophisticated") investors posess the knowledge/skill/experience to analyze even the most basic equity issue, let alone complex debt or structured products.
Most people can't even do a simple DCF for Felix's beloved utility companies, let alone figure out how to even approach analyzing some CDO^x.