PREPARING FOR THE NEXT BIG EVENT

Thoughts for the Week | September 21, 2018, #TFTW, #ThoughtsfortheWeek

“You get paid to worry so that I don’t have to.” That’s what a client once told us, and that’s a reasonable mission statement for our practice. We spend a lot of time thinking about what might go wrong and how to mitigate risks associated with “Big Events”. So we were intrigued when a client e-mailed last Saturday after seeing a financial headline â€œwarning about a bubble about to burst”, and asked how a long-term investor should think about the risk of “low probability/high consequence events”? 

The question is timely – nine years into the current bull market, with the 17th anniversary of the 9/11 attacks fresh in our minds, and last Saturday marking the 10th anniversary of the Lehman Brothers bankruptcy. We’ve also had clients’ families and their finances impacted this year by extreme weather events like Tropical Storm Lane, California’s devastating wildfires, and Hurricane Florence. 

So with that in mind, and with our own experiences riding out the 1987 Black Monday crash, the 1997 Asian financial crisis, the 2000-2002 dot-com bubble, the 2007-2009 financial crisis, and all of the corrections, earthquakes, tsunamis, and bear markets along the way, we thought that we’d pass along some lessons learned on preparing for and surviving “Big Events”. 

Most Predicted Big Events Never Happen

The media loves predictions of doom. Take â€œBull’s Final Countdown – How to Prepare”, the cover of the July 2nd, 2018 Barron’s. Dramatic headlines might sell magazines, but extreme events don’t happen as frequently as the media predicts them. As Barry Ritholtz of Bloomberg’s Masters in Business podcast series says “I wish an SEC-mandated disclosure accompanied all pundit forecasts: ‘The undersigned states that he has no idea what’s going to happen in the future, and hereby declares that this prediction is merely a wildly unsupported speculation.’” 

The Big Events That Do Happen Are Largely Unpredictable and Their Outcomes are Largely Determined by What You’ve Done Before They Happen

Negative big events do happen but it’s hard to predict their timing. Preparing for them can be more effective than reacting to them. We live in earthquake country, and we minimize their effects by having a “go bag” packed, making sure the water heater is strapped down, taking a hard look at earthquake insurance before a quake happens. Similarly, if you live in wildfire country clearing brush around your house, changing your shake roof for tile, doing a household inventory, and having adequate insurance coverage is a better bet than trying to stop a fire once it’s reached your house.

The financial equivalent of clearing brush and replacing wooden shingles is getting rid of portfolio leverage, avoiding speculative investments, and owning a high quality, fundamentally sound, diversified portfolio going into the event. But even high quality assets can move in lock step when buyers are few and far between, so be psychologically prepared for big swings in price.  

Howard Marks of Oaktree Capital points out that most portfolio moves that you might consider if you knew a big event was imminent destroy returns if the bad event doesn’t come to pass. The same can be said for most of the tactical, short-term advice that Wall Street pundits offer in times of stress. Advice like “Time to think about reducing equity exposure” or “Time to consider hedging your portfolio” requires an impractical ability to time markets and can be expensive for taxable investors realizing lots of gains.

You Need Water to Fight A Fire

Much of the damage in the Great San Francisco quake of 1906 was actually caused by fires. The quake started fires and damage to the city’s water system made it impossible for firefighters to battle the blazes. Large swaths of downtown had to be dynamited to create fire breaks to save the rest of the city.

During a big event cash is like water for investors. Understanding your sources of cash, thinking about how exposed they are to big financial events, and having a handle on your “burn rate” and cash needs is critical. Building a cash reserve that can fund a few years of living expenses can help investors ride out a bear market without having to sell a long-term asset to meet a short-term need. 

Avoid Unforced Errors

Running out of the house during a quake and having the chimney fall on your head is the equivalent of owning a solid portfolio and selling it when a big event materializes and the portfolio gets hit. Unforced errors, usually made when under emotional stress, can be devastating to your wealth so the importance of being mentally prepared for big events rounds out our lessons learned.

Enjoy your reading and your weekend.

Mike, Scott, Zack, Cate, Marina, Julia and Willis

Private Wealth Advisors

Mike Burbank, Managing Director Wealth Management

Scott Hafeli, CFA

Zack Schiller, CFP

Morgan Stanley Private Wealth Management  

555 California Street, 14th Floor | San Francisco, CA 94104  

Office: 415 576 3131   

Sources:

Barron’s, Bull’s Final Countdown – How to Prepare, July 2, 2018

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This illustration in this piece is hypothetical and shown for illustrative purposes only. The illustration is not intended to predict the returns of any particular investment, which will fluctuate with market conditions. Actual results may differ from those depicted in the illustration. The Burbank Hafeli Group at Morgan Stanley Private Wealth Management is focused on serving the investment and financial planning needs of the founders of food, beverage, and consumer products companies and private equity and investment banking professionals. Mike Burbank was recognized as one of the Top 400 Advisors in the United States by the Financial Times in 2013 and 2014. Scott was also recognized as one of the Top 400 Advisors in the United States by the Financial Times in 2015. 

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