TIB11: How to be successful with money? Just avoid catastrophe

TL;DR - It is vital to avoid a catastrophic loss when managing risk with your finances and life. If you can avoid a catastrophic loss, you can keep playing the game, and staying in the game is the most important thing.

Let me take you back a few hundred years in history to Saint Petersburg in the 1700s. While we are here, we come across a friendly local merchant named Lenny. Lenny has purchased some goods from Europe, and he is hoping to bring them home and sell them for a profit.

Before we go go any further, let me be clear. This is not a true story. Any resemblance to a real person is entirely coincidental, and hopefully does not confuse the hell out of you.

There is only one problem. The sea is filled with one of the oldest threats in human history: piracy!

In fact, this particular time period was known as the golden age of piracy. You had all sorts of pirates patrolling the Baltic Sea, raiding cargo ships and creating havoc for businessmen and civilians alike.

Lenny is faced with a dilemma.

How does he mitigate the risk of having his cargo looted before it reaches Saint Petersburg? To figure this out, let’s do a little math.

Lenny’s finances

• Savings = 2,000 Rubles

• Profit from the sale of all of the goods in one ship = 10,000 Rubles

• Total wealth after one successful shipment = Savings + Profit = 12,000 Rubles

The risk

On average, 5% of ships that travel this route are seized by pirates. That means that there is a 5% probability that Lenny’s goods never make it back to Saint Petersburg.

At first glance that doesn’t seem that bad. A 5% risk of seizure is something that can surely be managed. Lenny does some research and finds that he can fully insure his cargo for 1,000 Rubles.

Lenny is shocked! He has to pay 10% of the expected profit of his shipment to insure against something that only happens 5% of the time on average. There has to be another way to manage his risk.

Maybe he could divide the goods among many ships instead of having all of the goods sit on one ship (i.e., diversify his risk).

But this comes with added headaches, because it will likely raise his shipping costs which cuts into his healthy 10,000 Ruble profit. Moreover, if there is a pirate patrolling the few routes that there are to Saint Petersburg, it is unlikely he will only seize one ship and leave the rest alone.

So, what should Lenny do? Historically on average, Lenny is very unlikely to encounter any issues, and the insurance premium seems downright absurd.

But is it? Let’s dig a little deeper.

The real value of avoiding catastrophe

Although there is only a 5% chance of his ship being seized by a pirate, Lenny only gets to experience one event out of an infinite number of possibilities each time he decides to put goods on a ship bound for Saint Petersburg.

On average and based on historical data he will likely be fine. But while numbers, averages and percentages can make us feel all warm and fuzzy inside, a smart merchant should guard himself against catastrophe even if it means paying a somewhat exorbitant fee.

Why?

Because the penalty for experiencing some bad luck results in Lenny not being able to play the game again, and this is a loss that he cannot come back from.

This would be a catastrophic loss to his business. With 2,000 Rubles in savings, if he were unlucky enough to fall victim to a pirate seizure, he would experience a 10,000 Ruble loss that he does not have the savings to come back from.

When we consider the catastrophic loss that comes with this 5% risk of seizure, you can actually make the case that the price to insure his cargo is way too low. Without the insurance, Lenny risks never being able to participate in this business venture again.

So what should Lenny do? He should suck it up and buy the insurance. A certain 9,000 Ruble profit is better than a 10,000 Ruble profit that comes with a risk of never being able to do business again.

The takeaway

As much as it might seem like it, this story is not about the importance of insurance. Insurance is certainly a way to mitigate risk in our lives and in our portfolios, but this story is about remembering that the most important thing is to avoid the catastrophic loss.

On average, the market has returned around 7-8% a year over the course of the last 100 years. But that doesn’t mean the market returns 7-8% every year.

Some years it returns 15% and others it returns -25%. We know that if we play long enough, our chances of returning a positive outcome in the markets is very high. However, we have to make sure that we position ourselves to be able to keep playing long enough to take advantage of the historical averages.

Avoiding catastrophic loss (i.e., losses that put you in a position where you can’t play anymore) is vital. Whether it is in the markets, in business or in life, always try and make sure that you protect yourself against the catastrophic losses.

That’s why even though the risk of the market suffering a 50% downturn in any given year is extremely low historically, if it does happen you should have enough cash on hand to sustain you and your family through a potential catastrophic loss.

Nobody cares about the low probability of a horrible thing happening to them if it in fact happens to them. Doesn’t do anyone any good to come around and say “Shit, you are living through something that only happens 5% of the time. What rotten luck.”

We can’t control luck any more than our Saint Petersburg merchant can control whether his shipment of goods will be seized by Captain Jack Sparrow. What we can do is position ourselves to make sure that no one thing in our lives, no matter how remote the chances are, can prevent us from playing the game again.

Conclusion

What are some common mistakes that could lead to catastrophic losses (i.e., things we should avoid)?

1. Leverage - Playing with leverage (i.e., investing with margin and playing with money you don’t have) is a common way to risk catastrophic losses in investing.

2. Over-exposure - Exposing all of your portfolio to one company, industry or asset. No matter what you think of the prospects of a company like Apple or Google, exposing all of your portfolio to one company carries with it small probability that you suffer a catastrophic loss.

3. Forgetting a “rainy day fund” - Not having a rainy day fund that can keep you “in the game” to weather the bad times is a sure-fire way to suffer a catastrophic loss. Without a rainy day fund, you are more likely to make emotional decisions when the market is in a state of panic.

There is no bad risk, just mispriced risk. Always be on the lookout for catastrophe, and when you see it, no matter how small the risk is, make sure you guard against it like your life depends on it.

Recommendations from this week

Just wanted to give you all a heads up on some good stuff I have listened to this week. Hopefully you all find it useful.

For those who are a bit more advanced in their understanding of the markets

1. The Memo by Howard Marks

   Here is another one from Howard Marks. In this episode he discusses whether it is more important to cut your losers or find more winners in your portfolio. The answer, it appears, depends on what kind of investor you are and what you are looking for.

For those of you who are new to markets, investing and finance

1. Invest like the Best with Patrick O’Shaughnessy and Aswath Damodaran

   Patrick runs a great podcast where he interviews a variety of guests who specialize in different areas of finance and investment management. Each episode is very approachable no matter what your level of interest and expertise is. In this episode, he interviews a famous professor of finance at NYU’s Stern School of Business named Aswath Damodaran. In this episode, Damodaran has some thought provoking things to say about what each of us must do to craft our own personal investment philosophy.

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