In his letter to shareholders leading Berkshire Hathaway’s annual report for 2001, Warren Buffett penned his now-famous wisdom, “After all, you only find out who is swimming naked when the tide goes out.”
The metaphor does of great job of capturing how risk-taking can be hidden under the surface, but exposed to the cruel light of day after large reversals in market and economic activity.
In recent weeks, we’ve had a large decline in oil prices. Over the last six months, oil prices have fallen about 50% -- one of the largest such six-month declines in recent decades. The downdraft provides a useful reminder (as if we needed one) that all trees do not grow to the sky, and that prices can move violently and suddenly, with implications for financial market risk. Some investors are more exposed to oil price declines than others.
Public pension funds are some of the largest investment portfolios around. These massive pools of money stand behind, in many cases, even more-massive obligations to pay retirement benefits to government employees. The funding status of these promises varies widely around the 50 states, with some states now particularly underfunded relative to their promises.
In turn, there can be incentives for hard-pressed pension funds to take higher risks, particularly if decision-makers can get benefits on the upside with costs borne by a broad class of citizens and taxpayers on the downside. In this environment, states and cities that are run for the benefit of citizens should provide more frequent reporting than current practice.
A large six-month decline in oil prices may not be long enough to say the tide has really turned, but the metaphor still makes an important point.
We need to see who is swimming naked, sooner than later.