I have just finished  reading a book that has forced me to reconsider how I evaluate risk , because it discuss investing in a worse case scenario.

Evaluating risk has been an ongoing interest of mine because I assert that understanding risk is crucial to making sound investments.  If you overlook an element of risk then you may be exposing your capital to loss that you have not foreseen. Or, if your investment is successful, you may be underweighting the contribution of luck to your success. I have been a fan of people like Nassim Taleb the author of the Black Swan and Fooled by Randomness and James Montier because they helped we reshape my ideas about risk.

The book I have referred to in my opening is Wealth War & Wisdom by Barton Biggs. In essence it discusses the idea of maintaining wealth in one of the big black swan occurrences of the last hundred years, World War II. The book spends a lot of time on the history of World War II and weaves the ups and downs of financial markets into his tale. Biggs also  spends considerable time attempting to prove, but not quite succeeding, that the wisdom of markets is smarter than experts and world leaders. While I enjoyed the history and history of the markets during this apocalyptic time, I was most impressed with how he details that preserving wealth in time of war and upheaval is difficult at best. There are very few ways to preserve wealth let alone grow it.

How do we look at the potential of a great upheaval and its effects on our investments. Most people simply do not take into account.. Before you say that it is unlikely we will  face such difficult circumstances, remember that apart from a few very smart people, most investors did not anticipate nor profit from the Great Recession we have just experienced. It seems to be our nature to under prepare for extreme events.

Biggs offers  a few important ideas in his conclusion, some of which I subscribe to and some I do not. He asserts that the long term track record of equities favors a larger investment in them than other asset classes. In fact, he suggests that you invest 75% of your assets in equities, favoring index funds. He discusses the value of real estate and in particular farm land or ranch land as place that holds value but can also become a worse case scenario place to survive if the apocalypse hits your neighborhood. This farm should not be more than 5% of your wealth. He also suggest that you have to diversify your assets outside of your home country. That when the shit hits the fan, things turn quickly and we can often not get out of the way of the shit storm.

I don’t have many answers just questions that you need to consider. After all, the markets can be irrational longer than we can remain solvent. So being fully prepared for all contingencies is simply not possible. What will you prepare for and how is something worth considering. Below I have listed a few of the ideas that intrigue me as distinct possibilities, however remote. I am stating them with as a question. Perhaps, I will return with some answers later, perhaps you have some ideas to contribute. It is difficult to anticipate what the next Black Swan will be and what the unexpected consequences will be from that event.

What would you do to hedge against hyper inflation?

How about deflation?

What if we had an incidence of nuclear terrorism, that shut down a major country?

What if there is a double dip recession?

What if there is another financial panic?

What would happen if a major trading partner, say China, suffered a crippling natural disaster?

What if a sovereign debt crisis destroyed a major currency?

What if the price of real estate dropped another 50% from here?

What if headline unemployment rises to 15%, or higher?

What if  a cataclysmic event shut down much of the internet?

What if there really is a worldwide pandemic?

What if there is a major war that destabilizes a part of the world?

What if there is a major disruption in oil supplies in the middle east?

What if the Mayans were right and 2012 is an apocalyptic year? O.k. maybe not this one.

One Response to “Worse Case Scenario Investing”

1. Parker Bohn
   August 17th, 2010 @ 6:26 am

   This ties in to what’s been bothering me.
   I’ve been thinking about the nature of exponential growth and disasters.

   Let’s say that after inflation and taxes, you could in the long run get a 1.5% annualized return on your investments. Even Bogle-heads, who are known as conservative investors, would see this as a low-ball estimate.

   Now let’s take this to the extreme, and say this wealth compounded for the extreme long-term.

   2000 years looks good to me. At 1.5% per annum, $1 becomes $8.5 trillion.

   Of course, I don’t expect to live 2000 years, but this is such an absurd result, that the only possible conclusion I can come to is that even 1.5% is an unsafe assumption for long-term compounding.

   My hunch is that the exponential curve would be periodically destroyed by disaster.
   currency collapse, totalitarianism, genocide, plague, extinction of the human race, you know, stuff like that.

   But how often can we expect one of these events to take place? Once every 500 years? Once every 100 years?

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