Analysis of Normal Accidents as described by Richard Bookstaber - Essay Example

?“Normal Accidents” as described by Richard Bookstaber Introduction Financial investments are often done in relation to the prevailing global economic climate. Once there is a stable global economic climate, it can be expected that investors would invest more and the result of this is a booming global economic growth. Inversely, investors withdraw in their investment holdings if they find that they cannot trust the global economic trend. Once investors are convinced that they want to invest, there often exist several options for them. It is however very important to point out that the choice of investment is a very important decision. This is because wrong investments may lead to regrettable financial moments for the investors. The best that an investor may get out of a bad investment is cost aversion. In the absence of this, the investor may be very certain that he or she would be running at a lost. In some cases, the choice of investment is not necessarily what constitutes a bad investment for an investor. Rather, it is the approach used in investing. So an investor may be selecting the best form of investment but he or she may be approaching the investment wrongly. This is exactly the point outlined by Bookstaber in his book, A Demon of our own. The writer is very concerned about approaches that are taken by investors because in his opinion, a series of tightly coupled processes may only lead to normal accidents, which not as the name suggests, may be very disastrous. Normal Accidents Explained In his writing, Bookstaber describes normal accidents in relation to financial forces. The writer first uses scenarios of other forms of forces to explain his arguments of normal forces. The writer notes that “if you put in an extra warning light or sensor on a nuclear reactor or an airplane, that's one more thing that could fail, causing confusion and a disastrous cascade of cause and effect” (Fitch, 2009). In the same way, normal accidents in the financial sector arise as a result of compounding hopes of financial investments in only a single derivative. After the global economic crisis, many are those who judge the growth in global economics as exponential. This has resulted in a situation whereby most investors take the risk of taking up investments in accumulated forms. In the words of Fitch (2009), the situation causes “investors to bet on stocks, bonds and interest rates, often with a large degree of leverage.” The resulting consequence for such decisions is that there have been derivatives that have led to high levels of complexities in the financial system and this has led to normal accidents (Bookstaber, 2008, pg. 143). The concept of normal accidents as introduced by Bookstaber could therefore be related to the everyday concept of putting all of a person’s eggs in one basket. It is known that the resulting effect of such an action is that once the basket breaks the fellow losses all the eggs. In the financial sector, once investors become overconfident in their investment and channel all their funds to a single domain, the resulting effect is tight coupling and complexity Indeed, “the combination of tight coupling and complexity is a formula for normal accident” – especially when the structure of the financial system cannot handle the complexity. (Bookstaber, 2008, pg. 256). Tightly Coupled Processes in the Financial Sector In page 256, introduces a concept of structure of the system when he says that normal accidents are “accidents that are all but evitable as a result of the structure of the system.” The idea that this piece of information creates is that normal accidents are actually often influenced by the prevailing financial structures and system. Indeed, it is when the financial sector gets tightly coupled that investment decisions by investors may result in normal accidents. So what are some of the tightly coupled processes in the financial sector? According to the Best Currency Rate (2010), much of the determining factor in the creation of tightly coupled processes in the financial sector rests with Forex trade. In their view, there are decisions to be taken within the Forex trading and “these informed decisions are what separate successful traders from losing investors.” This point is supported by Bookstaber who claims that most decisions taken by investors have to do with betting on the stocks. Clearly, the trend of the stock money determines among other things, the Forex trade and strength of any given currency. It also influences other financial determinants like interest rate and inflation. In the long run therefore, the amount and trend of investment made on the stock market becomes the number one process for creating a tight financial structure and system. Therefore if an investor fails to trend according to structure and system determined by the stock market, there is the tendency that such investor would be facing the inevitable risk of normal accidents. Handling Normal Accidents Bookstaber makes a number of recommendations at the end of his book on how normal accidents can be handled. In simple terms, Booskstaber suggests a number of financial innovations. Most of the innovative suggestions that are given by the writer have to do with management decisions and these are related to empirical management decisions that have been taken by influential global financial giants. In the opinion of the writer, the trend for resurrecting one’s self from global economic crashes through normal accidents has to do with a switch from “Wall Street institutions to elite and highly leveraged hedge funds” (Bookstaber, 2008). In light of the Economist Special Report on Financial Innovation read for Module 2, there is an important connection regarding the switch to elite and highly leveraged hedge funds as suggested by Bookstaber. In the first place, The Economist (2012) notes that “the aim of many financial innovations is to make capital cheaper and more accessible.” The question therefore should be whether or not hedge funds make capital cheaper and more accessible. First, it is noted from the model that investing in hedge funds requires a lot of initial minimum investment. This means that the capital for investing in hedge funds may not be as cheap as propagated by Bookstaber. This therefore raises doubt if hedge fund is an ideal stake for dealing with normal accidents. On the other hand, it is known that because hedge funds require investors to leave their savings running for a period of less than one year, there are always higher returns on the fund. From this perspective, Bookstaber’s point may be justified as the outbreak of a normal accident may be cushioned by the final returns on the fund. Conclusion In conclusion, the use of hedge funds in combating normal accidents that result from prevailing financial structures and systems will be suggested not as a viable alternative to all groups of investors who may be seeking to overcome normal accidents. Rather, it is suggested for those whose initial capitals are huge enough to see them through this illiquid form of funding. Knowing that “in most states, hedge funds are not required to register with the Securities and Exchange Commission”, the idea to resort only to hedge fund as the only alternative financial innovation may be tantamount to an unsecure investment (Hedgeco Networks, 2009). To this end, investors are advised to partner their hedge fund investments with other forms of investments and funds. REFERENCE LIST Best Currency Rate. Limitless Possibilities. 2010. Web. April 7, 2012 Bookstaber R. A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation. New York: Wiley Publications. Print. 2008. Fitch, Asa. Richard Bookstaber: A demon of our own design. 2009. Web. April 7, 2012 http://www.thenational.ae/lifestyle/personal-finance/richard-bookstaber-i-a-demon-of-our-own-design-i#page2 Hedgeco Networks. What is Hedge Fund? 2009. Web. April 8, 2012. The Economists. Financial Innovation. 2012. Web. April 7, 2012. Read More