What Do You Do When the Sky Is Falling?
Extreme events are rare, but they do happen. Here are some concrete ways investors can prepare, says Willis Towers Watson.
China and the U.S. are engaged in a dangerous stare-down over tariffs, while Hurricane Dorian is bearing down on the U.S. after creating catastrophic damage in the Bahamas. Such extreme events, while rare, are still much more likely to happen than people have historically contemplated — and investors need to prepare, according to a new report from consulting firm Willis Towers Watson.
The 2019 Extreme Risks Report, released on Monday by the firm’s Thinking Ahead Institute, identified the top three risks in 2019 as a collapse of global trade, global temperature changes, and cyber warfare. Those risks are hardly abstract given recent events, according to WTW.
“We believe that the world is a complex adaptive system where sudden and violent regime change is possible,” the report stated. “In this description of the world, the tails of the ‘complexity distribution’ are considerably fatter than those of a normal distribution. That means extreme events are much more likely than we previously thought.”
WTW produces the annual report, which now covers 30 extreme risks, to help risk managers allocate resources and develop portfolios that can better withstand the effects of unlikely, but devastating, events. The risks WTW ranks range from fairly pedestrian (sovereign defaults, which are likely to happen but “endurable,” per the paper) to the outlandish (alien invasion, ranked as highly unlikely but “existential” in impact).
Tim Hodgson, head of the Thinking Ahead group in London at Willis Towers Watson, said the perception and impact of risks are always shifting, but can be real.
“If you live in the Bahamas, I wonder what you would think of climate change now?” he said in an interview. “We are dealing with extreme risks. We’re not saying they are going to happen. But if they do happen, they will have a big impact.”
WTW documents recommendations for investors, including hedging and adding diversification to portfolios.
“Diversity is a broader concept than diversification, and it refers to having exposure to as broad a number of different risk premia/return drivers as possible, in order to reduce the risk that forecasts about the future are ‘wrong,’” according to Monday’s paper. “This is one important element of the world view that we are proposing, and which should lead to more consideration of extreme events.”
But Hodgson believes investors really need cash, even if the amount varies over time.
“The more I’ve thought about it, the more I like cash, which is very untrendy for an investment consultant or investment adviser to talk about,” he said. “Most of the time cash is a drag when markets are rising. But from this extreme risk perspective, cash gives you massive optionality. I don’t think you should make a strategic 10 percent commitment to cash, but you can use it as a flexible risk management device. If a bloodbath or panic ensues, that 10 percent position, provided you are able to buy and aren’t paralyzed with fear, would buy you a lot of valuable assets.”
WTW preaches caution when it comes to derivatives, however. The cheapest derivatives apply to very specific situations, according to the consultant. “The fewer exclusions, the higher premium you’ll pay,” Hodgson said. “There is no holy grail asset that is a hedge against all bad outcomes.”
Hodgson also urges investors to study relationships between assets and the historical benefits of investments such as real estate. If global temperatures rise, the number one risk will be that land values will change, said Hodgson. He noted that some studies project that in thirty years, London’s climate will be similar to that of Barcelona’s today. With temperatures in Barcelona and other areas in the Southern Mediterranean rising, populations will want to move to cooler locales such as the U.K., Canada, New Zealand, and Scandinavia, according to Hodgson.
“Inhabitable land will go up substantially in value. I wouldn’t advise a villa in Tuscany,” he said. “Is land a negatively correlated asset to the risk of global temperature change? It depends which bit of land you’re talking about.”
WTW’s first report on extreme risks was in 2009. The consultant’s framework has evolved since then.
“I’m being a bit harsh on us, but it was like shutting the stable door after the horse was long gone. But the risk models at the time didn’t work,” Hodgson said. “Our work here is important, even if there is some danger that we’re offering the world some interesting thinking without a whole lot of comforting actions to go with it.”