You might be familiar with the World Economic Forum’s annual meeting in Davos, Switzerland, where leaders from around the world meet to discuss the most pressing issues facing our collective societies. The WEF produces a Global Risks Report summarizing the results, based not only on the discussions at the meeting, but also on feedback from hundreds of economists and other specialists in numerous countries.
One of the biggest risks highlighted in the 2019 report was not the possibility of a global recession, trade wars or political extremism. Rather, it was the risk of nuclear war using weapons of mass destruction. The logic behind this applies to your investment strategy as well.
The WEF report did not suggest that nuclear war is imminent or likely. The reason for putting it at the top of the list is because the consequences will be devastating. The same type of thinking is useful when purchasing insurance. It doesn’t make sense to insure against events that occur with high frequency (such as health care for managing colds or flu) because the cost of the premiums would be too great. Instead, we use insurance to protect ourselves against those rare occurrences (earthquakes or car accidents, for example) with a low likelihood of incidence but a big impact on our lives or on our pocketbooks.
When it comes to investing, investors commonly use averages to make decisions. The problem is that averages mask extremes. For example, over the past 45 years, a portfolio comprising an equal mix of large and small U.S. company and international company stocks would have gained on average approximately 10% annually. On the surface, that’s a pretty good return. A $10,000 investment in such a portfolio would have grown to nearly $730,000 today (excluding taxes).
However, in 2008 that portfolio’s value would have dropped by more than 40%, a loss exceeding $150,000. Investors expecting an average annual 10% return on such an investment would have been shocked.
As I have written before, there are various measures such as standard deviation, Sharpe ratios and Sortino ratios that financial professionals use to get a more accurate understanding of how bumpy the investment road had actually been. But they still won’t tell you what could happen in the future. How many times have we heard about a rare 100-year flood occurring somewhere in the world?
Research potential losses
If you are going to use historical data for investment decision-making, I recommend at least researching not just the average return, but also the biggest loss. That won’t tell you how much you could actually lose, but it would at least provide a benchmark you can use to determine the financial and psychological impact if such a loss were to happen to your portfolio. If you cannot bear it, then you should consider changing your investment strategy.
Also, try not to spend too much time worrying about nuclear war.
To read the WEF report, visit weforum.org/reports/the-global-risks-report-2019.