Risk aversion is a powerful force. Risk aversion is a subjective feeling that investors use to assess their preference for cash over risky assets. Risk aversion can change quickly and affects markets quite broadly. These are temporary effects that can be exploited for profit
On the face of it, Greece’s negotiations with its creditors are minor relative to the scale of global markets. Greek GDP is about USD 250 billion versus USD250 trillion for global market capitalisation – about one is to 1000. Wiping out Greece entirely should have little effect on global wealth, not that this is going to happen, nor anything close to it
Yet the headlines in the financial press foreshadowed crisis and global stock markets fell around 2%. How can this be? If the total risk to global wealth from a Greek collapse is far less than 0.1%, why do stock markets write-off 2% of wealth because of Greece?
The reason is that investors suddenly view cash in a new light, a safe haven, and they revise their attitude to risk-taking away from markets and into cash. In short, the Greek experience triggers a ‘risk aversion shock’ and the broad markets fall, regardless of the ‘fundamentals’ as given by the effects on future profits and cash flows from Greece itself
Like all sudden jumps in risk aversion, this shock is temporary and the markets will recover pretty quickly. In the meantime, there is profit to be made by investors selling cash to those who suddenly decide they need it