How to manage the risk of everything going wrong.
There it was again, the very tangible risk of something very bad happening. The coronavirus brought about fears of the unknown, the feeling of being helpless and that horrible premonition that things could get worse. The headlines were awful, people were dying, whole cities were quarantined, borders were shut, and yet still, the virus was spreading on a global scale. Not surprisingly, financial markets reacted, with some equity indexes down as much as 20%. The question on everyone’s mind was: could this be the beginning of the end?
This is what we call tail risk. The type of event that could wipe everything out, like a Tsunami that sweeps away all in its path. One day, we are having a great time with our investments, the next day everything could be at risk and we could lose it all. Memories of 2009 are still vivid in our minds, when some markets sold off as much as 85%, and everyone thought the world would end. It didn’t matter if you owned stocks, corporate bonds, or even real assets like property. If you had to sell, then these were the prevailing prices. So, what can we do to make sure that we don’t lose it all when something terrible of this magnitude happens again?
We could only invest in non-risky assets, but that would mean very low returns for a very long time, particularly with interest rates near zero. We could buy protection, in the form of put options on the markets or pay for some other form of capital guarantee? Perhaps, but that would be very expensive, as the people selling the insurance aren’t fools. We could also diversify our investments and make sure that part of our portfolio is always working? Yes of course, but you can’t protect yourself from everything.
The global financial system is connected, and it has to be, to allow the seamless flow of capital that makes investing so efficient. Like a sea of water, and capital moves in and out and up and down, and we all make money. Then a giant rock hits this beautiful well of tranquillity and what happens? Huge waves erupt from impact, and they cause further waves to rise and spread to eventually affect the entire body of capital.
If we are far away from the epicentre of the shock, the waves that hit us will be smaller and we can survive to fight another day. However, if that giant rock happens to hit us directly on impact, it’s over and there is nothing we can do about it. No more so than crossing the street and getting hit by a car. Similarly, if a virus shuts down an entire country, one that represents the second largest economy in the world and threatens to wipe out mankind, there is a limit to how much protection our strategic asset allocation model can offer. As disappointing as that realisation may be, there is great solace in knowing that we should not worry about things we cannot control. After all, that is what life is, and dealing with the unknown.