Protecting Your Portfolio Against the Unpredictability of Financial Crises
After a six-day double-digit percentage decline in global equity markets, many investors may be wondering if they (or their advisor) could have done something to anticipate such a pullback.
For a brief moment, many of us may find ourselves daydreaming about the financial gain we could have reaped if only we had liquidated our equity exposure as the market peaked and reinvested as prices bottomed out. But, sooner or later, we eventually wake up and remind ourselves of the unsatisfying truth we have known all along—the future is unpredictable and our prognostications are too unreliable to act upon.
Nevertheless, prediction has become firmly institutionalized in the world of finance and economics. Business operators, investment managers, policy makers, and academics are increasingly borrowing the methods of analysis used in the hard sciences—with the help of Ph.D.’s in applied mathematics, astrophysics, engineering, and the like—for the purpose of forecasting future stock price movements, inflation, interest rates, economic growth, corporate profits, and a multitude of other economic variables.
But, it does not matter how many Ph.D.’s you put on the job. What is non-measurable and non-predictable will remain non-measurable and non-predictable. It could be a war, a revolution, an earthquake, a recession, an epidemic, a terrorist attack, anything—it is impossible to predict with any degree of precision the catalyst of the next global downturn.
So, what’s an investor to do? It is not often explicitly recognized that there are two different forms of prediction. By way of background, we may attempt to predict (1) the arrival of a catastrophic event, but (2) we may also attempt to predict that if a shelter is to stand up to such an event, it must be constructed in a certain way.
Indeed, the first type of prediction is of greatest value. Predicting the arrival of a catastrophic storm, for example, would enable people to evacuate and avoid it all together. But in such cases where we do not have the ability to predict the arrival of a catastrophic event (e.g. an earthquake), it becomes necessary to focus our efforts on the second type of prediction: an understanding of what it will take to survive it.
Similarly, if we knowingly cannot predict the oncoming of a stock market correction, then we must shift our focus to surviving it without subjecting ourselves to irreversible damage. This brings us our solution in the form of a barbelled portfolio strategy—the combination of a safe portfolio that insulates near-term cash needs from market volatility and a long-term growth portfolio with commitments to a range of asset types diversified across regions, sectors, market cap, and style. In short, it is a portfolio construction process that addresses unpredictability by focusing on preparedness.
Now, what happens to those who fail to fully appreciate the difference between these forms of prediction? Consider the 2011 Fukushima disaster, in which a 9.0 earthquake triggered a tsunami that resulted in a meltdown of three nuclear reactors. People around the world were outraged at authorities for having underestimated the probability of such a failure occurring. However, this reaction misses the point entirely: when failure is too costly to bear, the likelihood of an event doesn’t matter—it’s the consequences that matter. This mindset leads to building smaller reactors and embedding them deep enough in the ground with enough layers of protection around them that a failure would not affect us much should it happen—more costly and less efficient, but better than the alternative.
The same lesson applies to investors: We know that shocks, crises, and pullbacks are inevitable—and we know they will be unpredictable in their timing—but with prudent portfolio construction and a long-term perspective, we are confident that outcomes for our clients will be favorable.