I moved to California with my family nearly 10 years ago. I have never regretted it. But early last Sunday morning, my family and I, along with others living in the Bay Area, were reminded of the downside of life in the Golden State.
Fortunately, last week’s earthquake took a greater toll on property than people. But in addition to providing a stark reminder of the costs (beyond sky-high housing prices) of living in San Francisco, it also was a violent, but good, metaphor for the dangers lurking in financial markets.
Stocks and other risky assets have been doing particularly well the last few years. So well, in fact, that it’s easy to forget there are risks below the surface. While I continue to believe that equities and other risky assets can advance further this year, it’s worth considering what to do when the next shock hits financial markets. Here are three investing lessons I took away from last week’s earthquake.
1. Shocks, by definition, are unpredictable; their performance isn’t telegraphed to anyone ahead of time. An earthquake is a very visceral reminder of that. In the financial sphere, while it’s true that a few smart (and lucky) investors got ahead of the last financial crisis, most missed the signs and few predicted the magnitude. And market shocks that are more exogenous in nature (think 9/11) are impossible to predict. Even today, while investors focus on the fragility of the Middle East or the conflict in Ukraine the next geopolitical shock could just as easily come from North Korea. When the next real shock, which I’ll define as something lasting more than a week, hits, the odds are few will see it coming.
2. Have your market downturn plan down on paper. In California, you’re supposed to keep an earthquake kit ready. Ideally, the kit includes food, water, a flashlight and other essentials. Our own earthquake kit is normally missing the first item: food. This isn’t a reflection of my wife’s preparedness; rather, it’s a function of my own bad tendency to raid the kit whenever I can’t find something I want in the kitchen. Going forward, I’ll have to break this bad habit.
For investors, the relevant preparation is to have a financial plan, ideally one consistent with your own objectives and risk tolerance. For example, when the next downturn hits, will you sell equities to limit losses or use it as a buying opportunity? The answer depends on your own financial objectives, stage of life and risk tolerance. But regardless of the details of the plan, you should have one ahead of time, and it ideally should be written down.
3. Build your portfolio for bad times as well as good. Portfolios, like houses, need to withstand the occasional shock. In the case of a house, this means retrofitting, earthquake insurance and bolting down the wine rack (as a bourbon drinker, my earthquake-related bottle losses were thankfully limited).
Recently, some investors have been ignoring this lesson. No matter how attractive or cheap stocks are, few investors should be 100% in equities, with the possible exception of the very young and very brave. But the longer the bull market goes on, the more tempted many investors are to abandon other asset classes and seek the higher returns of stocks. The problem is this behavior can leave you maximally exposed to markets at exactly the wrong time.
Investors need to build a portfolio consistent with their objectives, and for most, that means a portfolio that can offer downside protection as well as upside potential. This means it’s important to have some long-term strategic allocation to safe-haven assets – Treasuries, cash and gold – that tend to appreciate, or at the very least hold their value, when everything else is collapsing. While these assets may be a drag on returns today, they serve a purpose over the long term.
One final, non-financial point. Movies featuring an earthquake invariably have a scene with an animal getting agitated before the quake begins. In retrospect, this seems to be a bit of Hollywood fiction. Every single person I know said the same thing: their dog slept through the entire quake. In our case, the only reaction by our golden retriever was to look visibly annoyed when my wife turned on the lights. It seems we interrupted his sleep.