An earthquake struck off the coast of Japan in 2011. It was one of the largest ever, a magnitude 9. Yet, most seismologists believed it could never happen.
The earthquake itself did little damage considering its size. Nearby cities had been preparing for large quakes for decades. And they thought they were prepared for what came next.
The Tohoku earthquake triggered a cascade of events that led to the worst disaster in recent history. The earthquake triggered a tsunami, which breached the levees protecting the nearby nuclear plant, and things quickly spiraled from there. 98% of the total damage is attributed to the tsunami!
For natural disasters, it’s not a question of if, but when. Yet, we live with naturally occurring events every day. Californians, for instance, haven’t gone more than 12 hours without experiencing an earthquake — and that might actually be on the high side.
The reality is most earthquakes are small enough to go unnoticed. And small quakes occur far more often than large ones. So it’s not the small quakes we have to worry about.
From a risk management standpoint, preventative measures, like building codes, are put in place to withstand the big quakes. And the prevention works, for the most part. But on rare occasions, a quake comes along that surprises everyone.
That’s because most prevention is based on what we know, and what we know is limited. The data for earthquakes is incomplete. It only goes back so far, and the inaccuracy of the data grows the further back you go. It also fails to tell us the limits to how big a quake can be.
The few patterns that exist in the data offer little help in the way of predictions either. We know where they occur, but the time and size are unknown. In the end, the surprises serve as reminders of the limits of our prevention and that the biggest risk is not so much the earthquake but what else it might set off.
While there might be different forces at play, corrections and crashes in the stock market, are just as natural as earthquakes. The market fluctuates on a daily basis, but the tiny tremors are so common to be non-events. Every once in a while a correction comes along that makes us take notice. But it’s the big swings — the crashes — that create seismic shifts in our wealth.
Market data isn’t very helpful in finding out when the next crash might be. It really only goes back a century, the oldest data is less useful today, and the future is not limited to past market data. Which makes predicting the next crash practically impossible.
So investors are left in a similar bind as seismologists. We know crashes are inevitable. We have a rough idea of where they occur in cycles but we don’t know when or how bad it will be. So prevention is key.
We’ve learned over the years, generally, what it takes to survive a crash. Proper diversification, hedging, rebalancing, the ability to seize on opportunities, and good behavior are allies in protecting your portfolio. But protecting your portfolio is just the start.
The biggest risk in a market crash isn’t the drawdown but being forced to liquidate your portfolio to cover basic needs.
The goal of risk management is survival. That means not only surviving what the market throws at you but anything else it might trigger. We’re warned, for good reason, about the mistake of letting fear dictate selling in a crash. Yet, we overlook what job loss and inadequate savings might do to our portfolios.
Selling out near the bottom is a costly mistake but forced selling is much harder to recover from. A solid financial base — savings, insurance, etc. — is the best way to protect against the worst-case scenario.
- Other People’s Money – Net Interest
- 4 Investing Lessons from David Swensen – Of Dollars and Data
- David Swensen: The Peter Lynch of Institutional Investing – J. Rekenthaler
- Machines Can Make Us Better Investors – Klement on Investing
- The Fall of the Titans! – Research Affiliates
- Why Start-ups Fail – HBR
- Keynote Conversation with Cliff Asness, David Booth, and Eugene F. Fama (video) – Chicago Booth
- What Is Economic Growth? And Why Is It So Important? Our World in Data
- What Caused the Roaring Twenties? – Smithsonian
- Genetic Tricks of the Longest-Lived Animals – Knowable