In the simplest terms, basis risk is the difference between the hedge you bought and the risk that you own. Especially the difference that is most noticeable when you had expected to be needing the hedge.
But that is not the topic here. There is another Basis Risk. That is the risk that you are using the wrong basis to judge your gains and losses. This risk is particularly prevalent right after a bubble pops. Everyone is comparing their wealth to what they thought that they had at the height of the bubble.
Here are two stories that show the problem with that:
- Think about a situation where someone made an error in preparing your brokerage statement. That IBM stock you have was worth $100,000. The mistake was that an extra zero slipped in somehow. The position was recorded as $1,000,000. Add that in to your net worth and most of us would have an exaggerated feeling of wealth. Think of how destructive to your long term happiness it would be if you really came to believe that you had that extra $900,000? Two ways that could be destructive. First of all, you could start spending other funds as if you had all that excess value. Second of all, once you were informed of the error, you could then undertake more aggressive investments to try to make up the difference. The only way to be safe from that destruction is if you never believe the erroneous basis for the IBM stock.
- Possibly more realistic, think of someone in a casino. During their day there they bet on some game or other continuously. At one point in the visit, they are up by $100,000. When they leave, they are actually down by $1000 compared to the amount they walked in the door with. Should they tell people you lost $1000 or $101,000?
In both cases, it sounds silly to even think for long about the larger numbers as your “basis”. But that seems to pervade the financial press. Unfortunately, with regard to home values, many folks were persuaded to believe the erroneous valuation at the peak of the market and to borrow based upon that value.
So, now you know what is meant by this type of “Basis Risk”. Unfortunately, it is potentially much larger than the first type of basis risk. Behavioral Finance abounds with examples of how the wealth effect can distort the actions of people. Possibly, the reason that the person in the casino walked out with a $1000 loss is realted to the sorts of destructive decisions that are made when wealth is suddenly increased. Therefore, it is much more important to protect against this larger basis risk.
To protect against this type of risk requires a particularly strong ability to stick to your own “disciplined realism” valuation of your positions. Plus an ability to limit your own valuation to include only reasonable appreciation. Mark to mark is the opposite of the disciplined realism, at least when it comes to upside MTM. For downside movements in value, it is best to make sure that your disciplined realism is at least as pessimistic as the market.
This is a very different approach than what has been favored by the accounting profession and adoppted by most financial firms. But they have found themselves in the position of the second story above. They feel that they have made gigantic profits based upon the degree to which their bets are up in the middle of the session. They have not left the casino yet, however.
And that is the last place where disciplined realism needs to be applied. Most of us have been schooled to believe that “realized gains” are REAL and therefore can of course be recognized. But think of that second story about the casino. If you are taking those gains and putting them right back on the table, then you really do not “have” them in any REAL sense. Firms need to adopt disciplined realism by recognizing that a series of similar positions are in reality not at all different from a single position held for a long time. The gains should not be recognized until the size of the position is significantly reduced.
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