The Ascent of Money - Part 4
So far this series, Ferguson has taught us about the origins of money, the practice of lending, the emergence of banks, the invention of bonds, the formulation of the bond market, the origination of the publicly traded company, and the formation of the modern stock market.
In part 4 of the series, titled Risky Business, we move on to the next financial innovation that changed the financial world… insurance. In this episode, Ferguson shows us how insurance went from being invented to protect the wives and children of Scottish ministers upon their death all the way to the emergence of modern day derivatives markets, where some hedge funds make profits of billions of dollars a year.
The Ascent of Money (Part 4): Risky Business
The Nature of Risk
As human beings, we have a fundamental urge to protect ourselves against risk. Behavioral finance has taught us that a person’s aversion to risk is stronger than their desire for returns.
For example, when given the choice between a 100% chance of getting $40 or a 50% chance of getting either $100 or nothing, most people would choose the $40 even though mathematically, the average person would get $50 with the other option.
When it comes to your finances, you want to take note of how averse you are to risk when considering investments. We like to stress the value of safety, but if you’re earning 1% on your money, safety is going to work against you. So when evaluating an investment, it’s important to try to strike a balance between how much you think you could make and how much you can afford to lose if things go sour.
How Insurance Works
In its most basic form, insurance is basically a financial agreement that protects people against risk. The person who is covered by the insurance makes a payment (called a premium) to the insurance company and in exchange, the insurance company agrees to pay a certain amount of money to that person if what they’re afraid of happening actually happens.
The premiums the person pays are relatively small compared to the amount of money the insurance company would pay out should something happen. Otherwise, it wouldn’t make sense for the person to pay the premiums to the insurance company when they could just save those payments and have enough saved up to financially cover the tragedy.
You can buy insurance for a multitude of things these days - your life, your health, your home, your possessions inside your home, your car, and your portfolio among other things. However, just because a company is willing to sell you insurance for something doesn’t mean you should buy it.
It is important to consider the value of what you are insuring and then decide if you are really at risk of significant financial loss that would justify getting insurance. For example, if no one is financially dependent on you, you probably don’t need life insurance.
Likewise, if your car isn’t worth very much money, it doesn’t make sense to have certain kinds of coverage on it where the premiums will add up to more than the value of the car itself. Just keep the coverage that will pay for damage to other people’s property (which may be expensive) and injuries in case of a collision.
We’re not discouraging buying insurance to protect yourself, we just want you to take into consideration what kinds of insurance you really need so that you make good financial decisions.
A Quick Word About Derivatives
In the video, Ferguson spoke briefly about how derivatives went from being insurance for farmers to, as Warren Buffett called them, “financial weapons of mass destruction.” Derivatives can be wildly profitable investments for those who have an advanced understanding of what they are, how they work, and what risks are associated with them. This is what hedge funds do for a living.
Derivatives can also be wildly risky for both institutions and individual investors. This is partly because many of them are dependent on the value of other financial instruments or commodities whose prices can fluctuate for any number of reasons. The bottom line here… we recommend staying away from derivatives unless you’re extremely knowledgeable about how they work.
Go to the next post in the series - The Ascent of Money (Part 5) - Safe As Houses.
Learn more about Niall Ferguson at his website - NiallFerguson.com.
Buy Niall Ferguson’s book - The Ascent of Money: A Financial History of the World.
Want to learn more about the topics in this post?
Try our Google Search!