After the credit crisis and Great Recession, it seemed ridiculous to have thought that investing in subprime mortgages was a good idea. As with most market "bubbles," the risk of giving 7.5 million mortgages to people who couldn't possibly pay them off was somehow invisible to many investors at the time.
One reason such bubbles form is the tendency by many investors to confuse "risk" with "uncertainty." As the economist Frank Knight established, there is a subtle but crucial distinction between the two: Uncertainty is what good investors usually fear the most, because it cannot be measured or priced as risk can be. But when investors mislabel risk as uncertainty, they become vulnerable to the assumption that since it cannot be measured, they might as well ignore it.
That is exactly what is happening with the subprime carbon asset bubble: It is still growing because most market participants are mistakenly treating carbon risk as an uncertainty, and are thus failing to incorporate it in investment analyses. By overlooking a known material-risk factor, investors are exposing their portfolios to an externality that should be integrated into the capital allocation process.
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Via Chuck Sherwood, Senior Associate, TeleDimensions, Inc