Last month I wrote about pragmatic preparation around events like Harvey and/or Irma. I recommend reading it to get your mind around preparation for the events we have no or little control over.
Markets — risks vs. unknowns
In regard to markets today there are three real-time events that have occurred in the past two months that have risks and unknowns tied to them. There are reasons markets react differently than we expect.
Known risks are already priced into markets. The unknowns cannot be since we have no history by which to assess or “price” it. When the unknown becomes known is when you see major moves in the marketplace in order to adjust to a brand new known.
Volatility is the result of markets learning new information that was once not understood or fully known. Knowing the directions of those changes in advance can be difficult, if not impossible, to exploit.
Author and investment advisor William Bernstein refers to risks as deep and shallow. Shallow risks are risks that time will theoretically cure. For example, a bear market, a stock market pull back, or even events like the 2007–09 credit crisis. Diversified investments over long periods of time have historically recovered. This is primarily why he refers to investing as shallow, and why we say investing is a long-term decision, not a short one. If you have short-term needs, those funds should not be tied to long-term investments and vice versa.
Deep risks are risks that are generally not recoverable. Examples include war, devastation, inflation, deflation, and confiscation.
We have three real-time examples of both deep and shallow risks right in front of us today.
North Korea — war vs. rhetoric
Rhetoric is of little consequence other than for those who are glued to anxiety-inducing media influence. I recommend avoiding it.
War has history to it, and it is the winner that may benefit. I use that term “benefit” in the most skewed sense because war is never good; it is destructive and awful, and the benefits here are relative.
All war is different and this type of possible war — nuclear exchange — is a complete unknown. Markets cannot possibly accurately price this exposure because the markets literally have no idea what to do with an actual nuclear exchange. No matter how smart commentators may sound, they don’t know. That is what it means to be unknown. If a war of this magnitude actually happened, it would be devastating and unrecoverable to the people impacted beyond other long-lasting indirect impacts around the globe.
The markets currently are pricing in rhetoric, though. This is fortunate in that the markets generally are pretty smart to all known information. Let’s hope it stays that way.
(Continued)
Hurricane Harvey
This is a risk that already occurred and is now mostly priced into the markets. Much of the damages will not be covered by insurance. This is a tragedy of life and environment, while it is also a serious loss of wealth. A deep, unrecoverable risk has been experienced for many.
The unknowns, though, remain. They include the fact that so many people did not have adequate insurance, and the flood program combined with government funding will likely not be sufficient to return to par for many folks in Houston. This is a true destruction of wealth that cannot be replaced. Charity is one of the few sources of recovery for those impacted.
Hurricane Irma
This is also already a tragedy of life, environment, and property with more to come. This is a known risk combined with unknown. This is a deep and shallow risk, as well.
The pricing of risk is tied to insurance primarily. Insurance will most certainly take a deep hit, though markets can price this exposure. What they can’t price is the level of potential destruction beyond insurable property and to the loss of life, environment, and productivity. Again, charity is one form of help.
Destruction of this magnitude is a combination of shallow and deep risks, with the deep very difficult to recover from. The extent of the destruction is also an unknown, impossible to fully price. We learn of it after the impact and for years to come. Markets price in that “learning” as it happens. Both hurricanes will remind us a lot about shallow and deep risks, both known and unknown.
We can’t prevent a hurricane or war, but we can be prepared for it both in body, mind, and in our action plans.
We can also give to those who experience the deep risks. Most people simply cannot fully recover from a deep-risk event. I strongly encourage charity at a time like this.
MICHAEL DUBIS is a fee-only CERTIFIED FINANCIAL PLANNER™ and president of Michael A. Dubis Financial Planning, LLC. He previously served as lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.
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