Practical analysis for investment professionals
25 June 2013

This Is the Way the World Ends

Two of my colleagues and I were discussing the end of the world, a conversation prompted by some of my recent posts, as well as a call from an adviser seeking help with a client who has a nine-figure net worth and fully expects the world to end. In discussing what to do, we realized we hadn’t actually defined the problem: What does the end of the world mean? The last time we seriously had this discussion, in 2008–2009, we thought we knew what the end of the world would look like, but in talking it over, we realized we didn’t. So, in that vein, here’s my attempt to define various “end of the world” scenarios and what to do about them.

Threat Level 1 — The United States Today: Economic Uncertainty and Looming Hazards

Conditions: Where we were in the United States a couple of years ago, and arguably, still are today (i.e., high levels of unemployment, unsustainable government spending, large portions of the population unable to support themselves, but with social, financial, and real infrastructure intact). This is more of a warning state than an actual state of emergency.

What to do: There are many ways this situation can evolve, with the most probable way being an evolution back into stability. I believe that’s exactly where we’re now headed in the United States, but the opposite course is also possible. Because there are so many things that can happen, such as currency depreciation, interest rate spikes, stock market declines, and others, and no way to tell in which direction the situation is likely to go, a widely diversified portfolio is the best approach to prepare for Threat Level 1, with low-risk areas emphasized in all asset classes — for example, low-beta stocks in equities; short-duration, high-credit-quality fixed income; low-volatility and non-beta-correlated alternatives; and such assets as gold and real estate.

Threat Level 2 — Europe Today: Widening Financial Uncertainty and Social Stress

Conditions: An evolution of Threat Level 1 in which economic conditions have continued to worsen to the point that underlying infrastructure of all types has started to decay. We see different points on this continuum in Europe today, with Germany at one end (still close to Threat Level 1 but with rising risks) and Greece at the other end (approaching Threat Level 4). The social infrastructure has started to decay in many countries, with unemployment in Spain and Italy at unsustainable levels. The financial infrastructure has also begun to crumble, with banking systems collapsing in several countries and at risk in others. The political infrastructure is fraying as well, particularly in the countries most affected by austerity. Although things are still generally stable, the risk level is rising.

What to do: Along with the well-diversified portfolio previously outlined, moving assets between locations and currencies becomes important. For example, concentrations of wealth in real estate — which, by definition, is immobile — should be reconsidered, as should counterparty risk. For instance, who holds your assets, such as gold? Who holds your bank deposits? Are they stable? Could your assets’ underlying currency be revalued? For equity holdings, focus on companies that deal with necessities, such as food, rather than discretionary spending. For fixed income, consider default risk and loss on default much more seriously. Real assets, such as precious metals, become more important as the risk level rises and the financial infrastructure starts to decay.

Threat Level 3 — Iceland in 2008: Financial Crisis

Conditions: A breakdown of the financial infrastructure, putting all financial assets at risk. We saw this in 2008–2009, when financial asset pricing dropped significantly and the banking system froze because institutions would not trade with each other due to doubts about solvency. Because the banking and financial system is at risk, financial assets will suffer and may be lost, regardless of asset price movements (e.g., MF Global or Cypriot banks). Currency values may also be at risk (e.g., Zimbabwe). The social infrastructure hangs together. Iceland in 2008 is a very good example of this, with stocks down almost 90% and government bonds up 50%, down 45%, and finally down about 9% for the year. The currency collapsed as well, resulting in losses in local currency and even greater losses in the króna’s purchasing power in other currencies.

What to do: Diversify financial wealth among currencies, markets, and locations. Real assets are a hedge against financial devaluation and volatility, much less complete market failure. Invest in strategies geared toward making money in falling markets, such as managed futures and tactical strategies designed to go to cash. In times of financial stress, gold has historically been a good store of value. Real estate can directly protect against inflation and currency depreciation, with rising construction costs providing a competitive moat for existing properties.

Threat Level 4 — Nuclear War/Cyber War

Conditions: The financial infrastructure collapses, followed by the social and then the real infrastructure. Electricity is unavailable; water systems are unreliable; food distribution breaks down. This scenario could arise from a massive nuclear attack or potentially from a cyber attack that takes out the financial infrastructure and cripples utility systems. Implicitly, the damage is assumed to be deep and extensive enough that repair is not possible, and everyone must do their best to survive.

What to do: Given that you have enough money, you want a ranch with very few neighbors, your own water source, fields, and livestock, and a solar generation system for electricity. You’ll need all of that because it may be decades before something resembling current society exists again. For everyone else, particularly in densely populated areas, food will be the immediate concern because most areas will have very little food available and imports will stop. Clean water will become a concern shortly thereafter. Depending on the area, people who live nearby may well become a problem.

The upshot is that in any kind of Threat Level 4 scenario, most people will simply die, and the remainder will revert to a less ordered society. Worrying about financial assets will be pointless because they will have disappeared. Food and water will be the primary assets, followed closely by the means to protect them. In other words, it’s back to canned goods and ammunition.

Conclusion

Under the first three scenarios, diversification is the answer — not just among asset classes but also among currencies, geographies, and underlying strategies. As we have seen in different crises over the past several decades, some asset classes tend to do well in times of stress, and the effects of any crisis rarely affect the whole world in the same way. An investor in Asia would have benefited from holding dollars during the Asian financial crisis, for example, and an investor in Iceland from holding euros and gold in 2008. Although no strategy can eliminate all risk, proper and full diversification can dampen the worst effects of most forms of risk.

The fourth scenario, frankly, takes us out of the realm of financial assets. Should we really reach that point, martial law and military-led distribution of food and water in developed areas would be the best-case scenario until systems recovered enough to take us back to Threat Level 3.

The problem many portfolios had in 2008 wasn’t that diversification didn’t work but that they weren’t really diversified. If you believe a Threat Level 3 scenario is likely, you should have assets in many currencies and many countries, as well as in many asset classes, including real estate and precious metals. That certainly won’t eliminate the risk, but it may help blunt the worst effects.

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Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
W. Bradford McMillan, CFA, CAIA

Brad McMillan, CFA, CAIA, is the chief investment officer at Commonwealth Financial Network, a private independent broker/dealer, where he also leads the retirement consulting division. McMillan holds the CAIA, MAI, and AIF professional certifications. He holds a BA from Dartmouth College, an MS in real estate development from MIT, and a BS in finance from Boston College.

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