The things we forgot.

• Author: Adams, Tucker Hart
• Position: [the] ECONOMIST - Personal account

I'm getting tired of the current penchant for blaming everything that went wrong with financial markets and the economy on someone or something else. There is plenty of responsibility to go around, and much of it incorporates things we forgot.

The first thing we forgot is that diversifying risk doesn't eliminate it. It simply relocates it It's a bit like throwing the picnic trash on the ground instead of putting it in the barrel. The barrel may not be overflowing, but the trash is still in the park.

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One of the first things one learns in a basic finance course is that investors can lower the risk in their portfolios through diversification. Take a very simple example you have a portfolio com prised of a single stock. That was the case when I left a big financial institution 20 years ago to set up a consulting firm. This was before 401 (k)s were developed and our profit sharing plan required us to invest only in company stock.

By selling a portion of my bank stock when I left and investing it in other assets, my level of risk went down. This would have held true even if the second investment were a bit riskier than the first, since there was less chance both stocks would tank simultaneously .But overall risk to the economy wasn't reduced, it was simply reallocated. Now I held only a portion, with some other investor holding the rest.

This was forgotten in the orgy of credit derivatives and credit insurance and slicing and dicing and securitizing that characterized the last few years. I sat in a meeting 18 months ago with economists from a dozen of the largest financial institutions in the country and listened to them explain how structured investment vehicles had eliminated risk. They were absolutely wrong! They hadn't eliminated risk; they had simply redistributed it with no idea where it was.

The second thing we forgot was that markets require good information to function efficiently and effectively. In Econ 101, we studied markets comprised of an infinite number of small buyers and sellers, operating with perfect information. Of course, the real world is never quite like that. But the market still functions well if there are large numbers of buyers and sellers with good information.

The markets for home mortgages or auto loans or credit cards have a huge number of buyers...