Doomsday Scenario The Risk of Economic Evaporation

During the Mortgage Crisis, the Federal Reserve had to issue more than $700B worth of ‘stimulus’ funds towards saving the economy from economic ruin. Ignoring the ongoing debate about how effectively those funds were actually applied, I raise this example to illustrate how it is that the financial system is extremely interconnected. That stimulus money went towards leveraging multiple banks and insurance companies, and even nationalizing AIG.

Sure, we can diversify, hedge, and haggle our way out of plenty of risk, how can we possible accept huge catastrophes of volatility as being simply non-systemic (and therefore acceptable) risk? While we can’t completely negate this risk of economic evaporation (just as much as we can’t fully negate the possibility that we’ll make a profit 100% of the time in the market), we can take steps to ensure that our portfolio keeps these risks in mind, and therefore reduces our exposure to it. Specifically, we can use the end of the financial world as we know it as a deadline. Our objective as personal investors is to retire before the financial apocalypse.

Unless you go entirely short against a collapsing market, you’ll never be able to make a profit against the massive losses that will be coming. Given the situation we’re trying to address here, our only objective is to lose less money than everyone else, and therefore beat the market. This means that our regular personal investment objectives of pursuing income for goals tend to go out the window in the event of a massive liquidation. But rather than try and game the market by switching all of our positions into shorts at a moment’s notice, I tend to prefer a more persistent strategy.

Specifically, I try to usually include in my portfolio what I like to call an “apocalypse hedge”. What I will usually do is measure out at what point I feel as though a massive drop in market value of the entire trading index would result in a continued sell off due to sheer panic (in today’s market, I don’t need to look far).

This isn’t very hard for your investment advisor to handle, so I’d advise just farming out the technical analysis to them. Once I’ve determined this point, I’ll proceed to either buy a put that covers a general market index at that point (which is usually fairly inexpensive at that point, because it is so far out of the money) or sell a call.

The first of these actions is pursued when the market is rising, because it anticipates that the evaporation of the economy will take more than a single day, thus allowing me time to execute the transaction. The sale of a call is executed in periods where the market is declining, because it favors immediate cash-flow, and assumes that the market is going to disappear immediately.

Realistically, the market itself is not going to collapse in its entirety overnight (or in my option, ever). Regardless, the academic point provides a sober warning to any investor. There is pervasive risk in the market, and it is enough to cripple your portfolio in a moment’s notice. If nothing out, this week’s series on dooms-day scenarios demonstrates the value of holding an appropriate amount of savings, in order to survive through even the toughest of economic conditions.