The importance of tail-end events when investing
16 June 2020
At the beginning of the year, none of us would have imagined where we are today. It just goes to show that nothing can be taken for granted. Risks of every type should be considered and planned for. But how do you stress-test your plans for the worst-case scenario?
A chance decision
We recently came across this powerful story which changed one man’s attitude to risk entirely. We really recommend you take a few moments to read it for yourself to get the full impact.
In it, Morgan Housel describes the day when, as a teenager, he and his two close friends decided to go out of bounds skiing in the resort of Squaw Valley in North America. It changed his outlook on life forever.
Sometimes, we make a snap decision without giving it a second thought which turns out to have a major impact on the rest of our lives. That impact may be positive, it may be negative but the need to make a choice comes out of the blue and the consequences are impossible to foresee at the time.
What it shows about risk
Morgan uses the story to illustrate the three sides of risk:
The odds you will get hit
The average consequences of getting hit
The tail-end consequences of getting hit
We may all think about the odds of something happening. We may think about the likely outcomes of a certain action. But do we really push those thoughts to the limit? Do we consider the absolute worst that could happen?
Stress testing the worst-case scenario
Tail-end consequences are low probability but high impact events, such as the 2008 financial crisis or a global pandemic. The chances of an outbreak on the scale of COVID-19 may have been unlikely but the effects have proved devastating and widespread. So it’s important to account for such a possibility in your plans.
In terms of your financial planning, think about the variables, such as your spending, inflation, your life expectancy and the returns on your portfolio. Set an amount for each and see what outcome you’d get in normal times. Then vary the figures and see what impact that would have. If you’ve opted for a 60% equity and 40% bond ratio in your portfolio, what would happen if the stock markets totally crashed? Would you be able to take the hit? What impact would it have on your retirement plans? What if you didn’t get the level of returns you were expecting? What if inflation started to increase?
See how much divergence from your expected scenario you can tolerate. Push your plan to the absolute limit and do this regularly. See where it fails and keep amending it so you get as close as possible to what would be bearable.
Looking to the future
The lesson isn’t about never taking any risk. It’s about forcing ourselves to consider the unimaginable – and then something worse – and then making provision for even that eventuality.
As Morgan puts it, “We spent the last decade debating whether economic risk meant the Federal Reserve set interest rates at 0.25% or 0.5%. Then 36 million people lost their jobs in two months because of a virus. It’s absurd.”
Your plan has to be robust enough and flexible enough to accommodate the unforeseeable. None of us saw CVOD-19 coming. None of us built that into our financial plans. Tail end consequences have to be in there too. At the end of the day, they are all that will count.
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