You discuss the concept of “Armageddon protection” – insurance against particularly disastrous scenarios.  How should advisors hedge against these scenarios?

I worry because the minute we talk about the higher probability of market accidents and policy mistakes, it increases the severity of these failures if they come together.   At Harvard we introduced a “fat tail” protection strategy that has worked well during times of market dislocations.

I mentioned previously the four components of building a successful portfolio. The fourth component involves asking what a really bad state looks like, and if there is cheap insurance against it.  For example, when you buy car insurance, it is to protect against low probability and high impact events.  You do not buy insurance because you expect to crash your car; at least most people don’t!.  As long as risks can be partially insured cheaply, investors should be willing to forego some returns by paying out a premium.  The mindset is very important.  This type of tail insurance should run in parallel to the asset allocation process, and will be more important in the future.  I expect to see new products in the financial marketplace specifically for this purpose.

Turning to current events, you say that “the present turmoil is neither the beginning nor the end of the transformation phase.”  Can you discuss the turmoil and transformation going on in the financial services sector and how you expect it will ultimately play out?

Part of the thesis of the book is that there was a lot of noise in the system.  Instead of thinking this noise was a sign of something important, it was ignored.    People did not read the signals and got caught off sides when the market turned. The general sense of complacency was greatly facilitated by the proliferation of structured finance. 

This constituted a major innovation that, like others in history, was initially over-produced and over-consumed.  Investors did not look at how these structured products would behave under a full range of scenarios.  We now see the consequences – a lengthy process of de-leveraging and de-risking.  We see it everywhere – in investment and commercial banks and mortgage agencies

The trouble is that it is very difficult to de-lever simultaneously across the whole industry.  Firms must raise capital or sell assets.  As they simultaneously raise capital, the cost of capital goes up.  As they simultaneously sell assets, the prices of those assets go down.  Unless banks get a new balance sheet (through a sovereign wealth fund, the US government, etc), this is a lengthy and disorderly process.

I don’t believe it will end quickly.  A number of steps have to take place.   Any attempt to declare an early end to this crisis is premature.  It will play out over a long time.   Fasten your seat belt and don’t put yourself in a position where you have to be a forced seller.

Display article as PDF for printing.

Would you like to send this article to a friend?