This guest article is by friend of Monevator and former hedge fund manager Lars Kroijer, who is also the author of Investing Demystified.
The emergence of the coronavirus over the past two months has dominated the news and preoccupied the markets.
The virus is already having a real impact all over the world, as millions curtail travel and social interactions, and suffer financial or – worst of all – great personal loss.
At the time of writing, more than 4,000 people have died globally. The great worry is this number could increase dramatically as the virus continues to spread.
Stock markets plummeted again on Monday before rebounding on Tuesday – and of course nobody can know where they will go next. The expected future risk of the markets have spiked recently, too.
For as long as there continues to be huge unknowns about the path and severity of the virus and its economic consequences, uncertainty will continue to reign.
What – if anything – should we do about all this from an investing perspective?
Getting a VIX on things
The world may be in a panic state and markets have declined, but this is still overwhelmingly likely to be true.
Also, markets might be down and you may have lost money, but that doesn’t necessarily mean they will recover – no, markets don’t always bounce back.
The fact is that unless we have genius insights or a crystal ball, we almost certainly don’t know the future direction of the markets or even individual securities.
So what do we know?
We know that the world is now deemed to be a far riskier place for equity investors.
While not a perfect or long-term index, the VIX (a measure of predicted future risk of the equity markets) has increased from an expected standard deviation of under 15% to around 50% at the time of writing1.
This is important because it is the world telling you that your equity holdings are a lot riskier going forward than they were a month ago – though that’s perhaps an obvious point!
With this higher risk, it is not unreasonable to have a higher future expected return from shares from here, but then again the market is also telling you that very bad outcomes have become far more likely, too. Whether that impacts how you should adjust your portfolio really depends on your risk preferences and personal circumstances.
There is also every chance that your other assets – house, job, career prospects, and so on – have been impacted by the virus, perhaps indirectly, though you may not know it yet. This hit to your wider economic life will likely be far more muddled than simply saying you lost 20% in your equity holdings but your government bond holdings did quite well.
If you’re unclear about the potential impact and you have an advisor with insight into your overall financial situation, I would recommend a conversation. Focus especially on the liquidity of your assets and liabilities, and the likely increase in the correlation of the value of your various assets.
I don’t have any kind of unique perspective into what will happen with the virus or its impact on the global economy.
But as the volatility index is suggesting, it does seem obvious that the risk of a very bad state of the world has increased dramatically as the virus has spread across the globe.
So I think it makes sense plan accordingly.
In my book Investing Demystified I wrote a chapter called ‘Apocalypse Finance’ about what we should do at such times from an investing perspective, depending on the severity of the financial collapse. We’ve tweaked and republished this chapter below.
While things have obviously changed since it was written four years ago – and it doesn’t discuss any specific kind of disaster, let alone a pandemic – I hope you’ll find some useful insights.
Let’s consider the highly unlikely. Some would say paranoid. How bad can things really get and what might happen to our investments in a worst case scenario?
We obviously don’t know, but I think it is important to discuss how our investments would fare when all our plans are out the window and the world has gone haywire.
The title of the book refers to an age-old assumption that all swans were white. Swans had always been white and it had almost become part of the definition of being a swan – that it is a beautiful, graceful, white bird. The swan-watching community (if there is such a thing) was therefore aghast and confused when a black swan appeared out of nowhere. Everything the community knew and had taken for granted was suddenly in doubt when such a fundamental assumption as the colour of a swan could be shattered in an instant.
Taleb uses this parable to make a mockery of common parameters of risk used in finance. He describes how if you assume the annual standard deviation of the S&P 500 is 15%, then a drop of 45% would represent a three standard deviation move. Without skew or fat tails3 this should happen approximately 0.14% of the time, or about every 700 years. In reality it seems to happen every couple of decades! I’m grossly simplifying, but I think Taleb would forgive me in the interests of getting a complex point across in a paragraph.
Where am I going with this? I think we need to occasionally think about what most of us consider highly unlikely and undesirable scenarios.
Previously I’ve written about the short-term government bonds of the most creditworthy governments in the world, and how there are probably no securities that are lower risk than those.
But what if we, for a moment, allowed for the possibility of a complete collapse of society, with governments going bust and law, order, and property rights all negated?
The unthinkable is unthinkable
It’s hard for most of us to imagine what this kind of complete breakdown looks like without knowing much more about the reasons why it happened.
For instance it struck me as odd when watching the movie Contagion (about a lethal virus) that even with 40 million people dead in the US and in a state of complete panic, the main characters still walked around in clean clothes and drove their cars.
Would there really be functioning general stores and petrol stations with the world in such a state? Would your credit card be working? Electricity and water? Could you get your money from the bank – and if you could would that money be worth anything?
I am going against the logic of Taleb’s book in even discussing how society’s breakdown could happen or its consequences. Taleb discusses the ‘known’ unknowns and the ‘unknown’ unknowns, and to my mind basically concludes that we don’t know squat, other than the fact that unlikely events are more likely to happen than we think.
By even discussing ways in which the highly unlikely may happen and its consequences, in Taleb’s mind I may be missing the whole point that the unknown is exactly that, and trying to forecast it is a doomed undertaking.4
Still, how we protect ourselves and our loved ones from an investing perspective if society breaks would depend slightly on how it happened.
Was the disaster due to a massive natural shock that we survived? Was it war? Was it an epidemic that wiped out half the world’s population over a couple of months of sci-fi style mayhem?
Gold as security
The ownership of gold in such a meltdown may make a lot of sense. Over the past centuries gold has served as a great bartering tool, whether held as gold bars or in the form of jewellery.
Thinking of gold as a good hedge for markets that are so desperate that your investment in assets such as AAA-government bonds is worthless suggests a state of almost complete collapse.
We all remember the horrible stories from World War II when people bartered gold or jewellery for things like food or shelter or the possibility of escape. People who have studied history and worry that it may indeed repeat itself may find that owning gold has some insurance value to them.
One point of caution on owning gold: suppose you get exposure to it by owning a gold-mining company or an exchange-traded fund (ETF) that tracks gold. The value of those assets would track the value of gold closely as the world heads towards turmoil. But would they actually be of value to you in the case of complete breakdown?
Maybe not. Depending on the exact disaster there may not even be a functioning stock exchange where you can sell your gold correlated securities. And the bank where you held the securities in custody might be a ruin.
Perhaps as a cautious investor you have some gold bars at a very conservative bank in a vault that could withstand ten atomic bombs or whatever disease the evil spirits have thrown our way. But again, the gold here may not be of use to us when we need it.
Would the bank actually be open for us to go and collect the gold? In such a desperate state of the world would we trust that the employees of that bank had not broken into the vaults and stolen the valuables if that meant feeding their children?
Even in the case where you were able to go to the bank and pick up your valuables, you may not want to. In a completely broken-down society, imagine what it would be like to walk out of a bank with a bunch of gold?
You’d undoubtedly glance nervously over your shoulder as you exited the bank and police protection may be non-existent.
If not gold, then what?
Obviously the scenarios I describe above are extremely unlikely. Major disasters of such magnitude have only happened a couple of times over the past century. Even in those cases it was not disaster everywhere in the world, simultaneously. Of course those caught up in the horrors of war or mayhem will find it scant comfort that things are better elsewhere; they are forced to deal with what is in front of them.
If you can’t realise the value of securities or even pick up valuables in a safety box at a bank then the breakdown of society as we know it today would be so complete that we individually would probably be worried about other things, such as shelter, security, food, and water. Probably the last thing on our minds would be how to best invest our assets. Indeed people with the paper version of this chapter would probably burn it for warmth, while mocking the memory of the orderly and stable society most investment books take for granted.
In certain circumstances, ancient jewellery has historically been a preserver of wealth in times of great distress. It is easy to store, hide, and transport. That said, as with gold I would caution you against storing lots of expensive jewellery at home: the risk of theft could quickly eliminate any benefit from holding it.
In certain cases property may be a good asset in times of extreme distress – even if it is illiquid for immediate use. Besides the possible benefit of it as arable land, if the crisis passes there may well come the day where the rule of law prevails and you can reclaim your assets. While shares in companies may be worthless with the companies long gone, property may maintain some value.
Finally, there is some protection through the holding of the broadly diversified portfolio. Although the scenarios discussed above are clear calamity scenarios, there is some chance that part of the portfolio will survive and maintain some value as a result.
Even in our highly interconnected world, a global tracker is geographically diversified. Holding securities in companies in diverse locations such as Australia, Brazil, Canada, Europe, the US, China, and Japan may be of some value if calamity strikes your London home base. For all the securities in such a portfolio to be rendered worthless a calamity would have to strike simultaneously all over the world.5
How could 2008 and 2009 have happened?
My point with the crazy stories above is that your best investments in times of great distress depend on how you define ‘great distress’.
If you define great distress as what happened in 2008, then a AAA-rated government bond is indeed a great preserver of value. In fact things could have gone a whole lot worse than what happened in 2008 and that would still be the case.
But although my suggestions of societal breakdown may seem alarmist or like scenes from a bad science fiction novel, if we’re talking about extreme ‘black swan’ events then conventional thinking is redundant.
I remember talking to a few friends at collapsing financial firms during October 2008 and again in March 2009 as they were navigating their way through the mayhem. One phrase I remember hearing a couple of times, mainly as a joke, was: “If this gets any worse, it’s guns and ammo time.”
While I chuckled back then, it was interesting and scary to see how fast the world could go into panic mode, even without a trigger like war, epidemics, or natural disasters. This was a panic caused by the falling house of cards that most of us had helped build through the creation, purchase, regulation, complicity, or ignorance of a crazy, headless, expansion of credit.6
As bad as things were at the worst point of the 2008–09 crisis, they could clearly have been much worse. There were still functioning financial markets, no governments had defaulted (they had in fact been able to oversee large and necessary bailouts), there was no hyperinflation or threats of war, and there was no widespread civil unrest.
Suppose that instead of the world recovering from the darkest days of the 2008–09 crisis, things had taken a turn for the worse.
We would probably have had a complete collapse of the financial system. Virtually no banks would be in business, or at least not be operating like we take for granted they do today. Your insurance policy would probably be worthless, with the underwriter bust. Many governments around the world would be unable to meet their short-term debt maturities and be in default. There would be nobody with liquidity to buy their debt.
With no functioning financial institutions, trade and commerce would completely dry up. Why would you deliver goods to store when there was no real way you could get paid? Similarly, petrol stations might not be working and public transport would be a mess. (An informed friend told me that the UK has about three months of food reserves and six weeks of fuel, assuming normal consumption patterns.)
Tax revenues would plummet further, as there would be far lower incomes to pay tax on and commerce would have come to a halt (so no sales tax or VAT). The absence of tax income and the inability to refinance short-term bonds would cause the government to cut back severely on spending, including benefits, pensions, education and medical care. Sensing what was in store though, the government might increase spending on police and the military. With the inability to fund itself the government might start issuing IOUs (promissory notes), but these could lose credibility quickly as it became apparent that the prospect of repayment was poor.
People who lost out to these major government cutbacks would probably be extremely agitated. Civil unrest might break out. We have seen cases of civil unrest (like the London riots) or larger protests at government spending cuts in relatively normal states of the world. But since the picture I’m painting is much worse, we can assume that even more widespread unrest could dominate. Where all this could lead is anyone’s guess, but probably nowhere good. The whole infrastructure of society would come under great stress.
The scenario I describe above probably won’t happen in my lifetime, the lifetime of my children, or even the grandchildren I hope to have one day. Or at least I hope it won’t! My point is to demonstrate that we must have a flexible mind when we consider all the possible outcomes in our investing lives.
The question is: how should we think about investments in a state of complete societal breakdown, not seen in my lifetime, at least in the Western world? These could include potential scenarios where property rights have broken down, there is no police or food on the shelves of the stores, and your money is worthless anyhow.
As I see it, a simple passive portfolio mixing a global tracker with your minimal risk asset – what I call a ‘rational portfolio’ – remains superior in virtually all states of the world, except in the scenario where the world is left without property rights and all investment assets across the world are worthless.
- Depending on the level of breakdown, we could still be safe with AAA-government bonds (though they would probably not still be AAA anymore) – potentially from countries other than our own.
- In slightly worse scenarios we would probably want to own fixed assets such as a house or property. There would still be value somewhere in the broadly diversified rational portfolio, as the whole world probably would not go bust all at once.
- In an even worse scenario than this where property rights are out the window, we would probably want to own high-value yet easy to hide and transfer goods like gold or jewelry.
- In complete mayhem we’d want shelter, security, food, and water. And indeed guns and ammo.
If you are inclined to think the worst is remotely possible then perhaps Google ‘preppers’ and explore the world of people who are actively preparing for the collapse of the world order as we know it. Personally I think they are paranoid and a bit crazy, but they would equally consider me naïve.
Finally, the emergence of virtual currencies/commodities like Bitcoin may someday provide additional financial shelter and be a potential alternative to gold. These cryptocurrencies are still in the nascent stages, but if they end up as a recognised asset that can be stored securely I wouldn’t be surprised to see their value go up at times of turmoil and stress in the financial markets. I would caution you to consider risk of being hacked though – particularly at times of lawlessness – and also to think about whether there would be enough ways for you to practically utilize your Bitcoins, either via payments for goods, or else to translate them into the fiat currency you’d need to spend.
Oh, and if you’re going to fill your cellar with tins of baked beans then don’t forget to also pack a tin opener!
- 10 March 2020
- The Black Swan: The Impact of the Highly Improbable (Penguin, 2008)
- i.e. Big moves that are more likely than suggested by a normal distribution.
- Though paradoxically he also discusses buying government bonds and put options to protect against calamity, which both assume somewhat functioning financial markets to profit from the disasters.
- Many companies in the world equity portfolio have large net cash holdings (Apple has over $200 billion in cash at the time of writing) unlike governments, which are typically large net debtors. In a really nasty world scenario those cash holdings might prove invaluable and ensure they survival longer than many governments! To ensure you actually own those underlying stocks you would want your ETF to be physical, as opposed to synthetic, where you take credit risk with the issuer.
- I recommend reading How I Caused the Credit Crunch by Tetsuya Ishikawa (2009, Icon Books). Tets, who was very involved with crisis events while at Goldman and Morgan, wrote a funny book about the financial crisis.