Oxford dictionary’s definition: lack of incentive to guard against risk where one is protected from its consequences, e.g. by insurance.
The Unintelligent Investor’s explanation
Moral hazard is usually described by insurance companies. As Oxford dictionary explained, it is the lack of incentive to guard against risk. For example, if you own a car and it is insured, you might leave it unlocked, or drive recklessly or park it outside even though it is going to hail, etc because you are insured. So you have the lack of incentive to look after your car and protect it against damage because you know if your car gets stole, you can claim money from the insurance company and buy a new one. So in that case, the insurance company is exposed to moral hazard and I’m sure that is factored into their premium calculations.
In investing terms, us as investors are exposed to moral hazard if we invest in funds, or banks or any trader. This is because the managers do not fully bear the cost if things go badly. If the managers make a bad decision, they lose our money, not theirs. As a result, they might take an unnecessarily high amount of risk because it is not their money to lose. Just look at the big banks in America, their blunders are not only paid for by the investors, people lost their houses and on top of that, tax payers had to cough up money to bail out failing financial institutions. Some fund managers lost their jobs but some pocketed millions more.
Moral hazard also happens when there is no full disclosure of information. Fund managers don’t always tell us how they invest our money or how they plan to. A lot of the time we put our money in the fund and has no idea what is happening to it. As long as there is a profit, we don’t really care where the profit came from (very evident in the Bernie Madoff case). So the managers are not only insulated from risk but they also have more information about their actions and intentions. Us as investors just have no idea.
So remember about moral hazard when investing in a fund. Remember to pay special attention to how a fund manages risk. What do you think? Do you have any idea how your fund manager manages risk? Do you have any idea where your money is going to?
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