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The Covid-19 pandemic is causing people to re-learn an important financial lesson. Perhaps this time more people will remember it than usually do, because the lesson can prevent substantial declines in wealth and reduce stress and worry over the years.
The lesson is that about every 10 to 15 years we experience an event that has a low probability of occurring but has a high cost when it does occur. Each of us needs to be prepared for such events all the time. While sometimes they can be forecast, most of the time there’s little warning that the probability is tilting from low to very high.
Some of these events are global, national or regional, affecting a large number of people. We can look back only 20 years and recount hurricanes and other natural disasters, the 9/11 attacks and the financial crisis. There also were shorter-term market events such as the taper tantrum in the bond markets, the flash trading crash and more.
Other events are more local or even personal. These can include accidents, serious illnesses, the need for long-term care and others.
Some of the events will be new and previously unknown. Others can be recurring.
Most people are prepared for some of these events, through auto, home, and medical insurance for example. But few think about or prepare for the potential national and global events.
The widespread events never are the same, but they have very similar results. Lives are disrupted. The markets and economy turn down. Money is lost.
It can be fun for a time to ignore the potential for such events and leverage the good times to maximize gains, but the gains are ephemeral when there’s no plan for the potential bad times. The specifics of the coronavirus pandemic weren’t predictable. But it was foreseeable that at some point there would be at least one global event that would disrupt trade and transportation and bring at least parts of the economy to a halt. One could imagine fighting wars, trade wars, political conflicts that lead to sanctions and others.
Each of these events has a low probability of occurring. But when the probability of each individual event are added, there’s a high probability that sometime very bad will happen every 10 to 15 years.
One can decide to buy insurance for the events for which insurance is available and decide to ride out the effects of the other crises until things turn around. After all, looking at the long-term, the effect of each of these events on the markets and economy is merely a blip in the long-term upward slope. That approach can work fine for those who are relatively young. But those who are in or near retirement might not have enough time to wait for the eventual recovery. Investment returns were low for a long time following the Depression of the 1930s and the stagflation of the 1960s and 1970s.
It’s safer to assume a bad, unpredictable event such as Covid-19 is in the near future. That doesn’t mean putting all your portfolio in cash. But it does mean ensuring each of your investments has a margin of safety and that you manage risk in your portfolio. I recommend that no matter what your outlook for the markets you always have adequate diversification and balance in your portfolio. You always want different investments in your portfolio so that a portion of the portfolio will do well in almost any economic and market environment.
It’s a safe bet that one of these rare events that has high costs and low probabilities will occur every 10 to 15 years. We need to be prepared to experience a “once-in-a-lifetime event” with some regularity.