This posting is really a follow up to a thoughtful response I received from Parker Bohn, one of my readers, to my post Worse Case Scenario Investing. Here is his part of his comment,

“…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…

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?”

That is some stress test!

In the extreme nothing human endures. 2000 years ago the Roman Empire dominated the Mediterranean world. A safe bet was that they would rule for two thousand years because they so completely dominated the financial and political world of their time. It seemed, using Buffett terminology, that their moat was unassailable. And it was for a while. But not two thousand years, only 500 years more or less.

The United States as the dominant financial power is unlikely to survive even another century without cataclysmic economic  or political events. If anything, the inevitability of wealth destruction has increased not decreased in the past century. And the increasing interconnectedness of today’s financial markets speaks to the increasingly complex notions that must be used to protect wealth in extreme events. Nobody should buy and hold forever, even if it works in one generation, it will almost certainly not work in the next generation. Flexibility and adaptability may be the only way to preserve wealth over the extreme long term. Rule number One is after all do not lose money. We don’t need to look at 2000 years to achieve the extreme long term. 100 years seems sufficient.

Of the original Dow Jones industrial average only one company, GE, is still a functioning independent company. Thus the odds of a buy and hold philosophy are not good in the extreme long term even if that extreme is only 100 years. We have  had a pandemic, two World Wars , the Great Depression and lately the Great Recession in the last 100 years. All wealth destruction events. It seems to me that No generation survives without some catalysmic financial event, even if it is not as destructive to humanity as war or pandemic.

It also occurs to me that part of why Parker has identified the absurdity of steady long term accumulation is that there is simply no way to win every year in investing. For example, if you have a nasty bout of hyperinflation, you are unlikely to earn excess return of 1.5% on top of the ever diminishing buying power unless you are leveraged. On the flip side in an extreme bout of deflation any substantial debt, say a mortgage, can sink most investors. It is simply not possible to be hedged for all disaster contingencies and still make a return.

The old adage comes to mind, the market can remain irrational longer than we can remain solvent. I think there is a corollary to the fat tail risks looking forward. The markets may be rational, but that may not help you preserve your capital in the long run. I do not know if wealth destruction is inevitable but I do know that longer you invest the greater the likelihood that you will be exposed to a fat tail, or extremely unlikely, wealth destruction event.

5 Responses to “Is Wealth Destruction Inevitable?”

1. Parker Bohn
   October 6th, 2010 @ 9:33 am

   Thanks for the excellent follow-up.
   I feel like we are having a slow motion conversation here

   What we seem to be talking about is long-tail events. It seems to be a fact of the world that sudden, extreme events are almost always negative, and not positive.

   For instance, my house could burn down tomorrow. The odds of the reverse event happening (me suddenly gaining a house) are much lower.

   My expected remaining lifespan is many decades. This could be suddenly shortened to zero in any number of ways, but is unlikely to suddenly double.

   A plane can suddenly crash, but not suddenly ‘uncrash’. A stroke could suddenly erase a lifetime of knowledge, but there is no ‘unstroke’ that suddenly gain a lifetime of knowledge.

   A civilization can be quickly destroyed through famine, disease, or genocide, but a new one can’t be quickly built out of nothing.

   This is true of any complicated system. Society & economics are a process of gradual building, with occasional (hopefully rare!) events of destruction.

   Being clever animals, humans can try to mitigate these risks. Insurance spreads the risk of house fires quite effectively, for instance.

   But the really big events, the longest tails, can’t be insured away, because they are too big. And these are the biggest risks by far, not just to our retirement funds, but to our way of life, and perhaps our entire species.

   This is why I question people’s assumptions of continuous exponential growth, regardless of the rate they assign to that growth.

   Unfortunately, there is no other game in town. So we’ll just keep exponentially growing (and I’ll keep investing) until one or more horrible things happens.

   Hopefully ‘the big one’ won’t happen for a few 1000 more years.

2. Parker Bohn
   October 6th, 2010 @ 9:42 am

   An interesting examination of exponential growth:

   The Dow Jones Industrial Average started the year 1900 at 68.13. 100 years later, on Dec 31, 1999, it closed at 11,497.

   Based on this data, I am projecting the future of the Dow:

   In the year 2100, the Dow will be 1,940,170
   In the year 2200, the Dow will be 327,405,467

   At this point, a daily move of several million points on the Dow should be common.

3. chroma
   October 8th, 2010 @ 12:28 am

   Yes we are. Of course we are talking about fat tail events. While negative “black swans” seem easier to conger in the mind, that does not mean they are more common. We may excluding elements that we simply identify as luck.

   I work in the film and television business. Every single successful film or t.v. show is a black swan. But we are accustomed to think of these events as skill or talent based. Taleb is correct on this front, we have difficulty identifying the difference between skill and randomness. Bad luck we call black swans or fat tails. Good luck we think of us as our skill or destiny, but ignore the randomness involved.

   If you have a mortgage and a steady job that increases your wages with inflation. Imagine an episode of hyperinflation. You will have a black swan in your favor. Your mortgage debt will be shortly worthless, increasing your net assets.

   I love the dialog Parker. Keep it going.

4. Parker Bohn
   May 7th, 2011 @ 1:11 am

   Well, I now notice that at least one prominent person is saying the same thing I am.

   Here is a link to an article by Jeremy Grantham:
   http://www.energybulletin.net/stories/2011-04-29/time-wake-days-abundant-resources-and-falling-prices-are-over-forever

5. chroma
   May 27th, 2011 @ 7:56 am

   Parker,

   Thanks for the link. I had read what Grantham said as part of his latest letter. He is always an interesting read.

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