Catastrophic Loss

In those long-forgotten, pre-Covid days, I was typically on the road anywhere between two and five days a week.

I am a pretty comfortable flyer. But on more than one occasion, especially when taking off in bad weather or on a dodgy airline (sometimes a combination of both!), I would ask myself:

What if?

I mean, accidents happen.

Before you ask, yes, I am very familiar with the stats. I am well aware of the fact that flying is much safer than driving.

Then again, I haven’t owned a car for about ten years now.  And while flying may be safe on a relative basis, I’m not exactly improving the odds every time I board a plane, am I?

Now, as unfortunate as dying in an airplane crash would be, I feel well covered on that front.

I’ve got a sizeable life insurance policy, which I’ve been increasing as our family grew in size.  In addition, my deferred bonuses would continue vesting if something were to happen while I am traveling on business.

Just as importantly, my wife is fully clued up on our financial matters and we discussed a contingency plan in the past.

But the broader point still holds.

Oftentimes, we are so focused on solving for the upside (i.e. building wealth) that we forget to protect the downside – with dire consequences.

Bad Business

Mercifully, the list of things that one should really worry about is quite short. To me, it’s:

  • Death
  • Disability
  • Divorce
  • War or another existential crisis

As far as the first two items go, see above.  Sure, crap happens.

However, such crap is rare and can be effectively managed with an insurance policy.

Then there’s what I call self-inflicted disabilities.  The kind of health deterioration that inevitably happens when people don’t look after themselves (and I’m certainly guilty of this one myself).

Not much to say here either, other than to suggest staying active, watching your diet, and avoiding stress.  Extra points for not smoking, keeping a moderate alcohol intake, and saying no to drugs.

There’s zero point in getting rich, only to realize that you can’t enjoy the money anymore.

Divorce is the next big one, and it definitely deserves its spot on that list of gnarly outcomes.

Put simply, divorce is NEVER good news.  Your choice of a life partner is probably the most important financial decision you’ll ever make – except you don’t even realize you are making one at the time.

But people do get divorced.  Just because you made a bad decision in the past doesn’t mean you need to stay in an unhappy (or worse) relationship.

Exit quickly, and hopefully amicably. The costs of divorce proceedings go up exponentially once lawyers get involved.

And once you are in the clear, try not to make the same mistake again.

Finally, there’s war. Most of the readers of this blog are from countries that haven’t experienced war for generations. Chances are, that will remain the case.

Sadly, not everyone is so lucky, and nothing can destroy lives and livelihoods quicker than armed conflict.  There’s a reason that money (i.e. investment) loves peace and quiet.

There’s also a reason why so many people who make their money in emerging markets tend to have a second base of sorts somewhere in Europe or the US.  Housing prices in London and NYC are not an accident.

The Long Tail

Once you get past the short list of really bad outcomes, you can turn your attention to the slightly longer list of risks that could just as easily torpedo your financial situation.

For the avoidance of doubt, I am not talking about market crashes.

Those are a feature, not a bug, of the financial system.  They are the reason we get that nifty equity risk premium and can contemplate early retirement in the first place.

Much better to focus on things that allow us to survive those inevitable crashes – and stay in the game for as long as we can.

Leverage is the biggest elephant in the room.  When the times are good, amplifying your returns with some debt seems like a total no-brainer.

But leveraged investing is like one of those really sharp Japanese knives.  Very helpful when used properly – and just as dangerous in inexperienced hands.

Then there’s diversification.

As hard as that is to believe, the vast majority of stocks actually underperform Treasury bills over their lifetimes.

The few that buck the trend, outperform by an absolutely astounding degree and power the magic money machine.  But… good luck identifying them before the proverbial home run.

Investors who build their wealth through index funds are usually okay on the diversification point.  It’s part of the package.

However, there are a lot of people who build wealth outside the stock market (i.e. entrepreneurs) or simply inherit it.

If you are in that camp, it’s worth remembering one of the fundamental rules of money:

You make money with concentrated bets – but you protect money with diversified ones.

Finally, for those of us relying on the good old nine-to-five, a big potential curveball to watch out for is a layoff.

Not critical if you are in the right industry with the right skill set, and just happen to be working for the wrong company.

A healthy dose of networking (ideally before the event) can help you land on your feet.

Much more challenging if you are highly specialized and happen to be stuck in an industry in a secular decline.

The very reason some jobs pay more than others is that they come with inherent downside risks.  Keep your eyes open and be honest with yourself, as retraining and repositioning yourself can take much longer than you think.

Glass Half Full

The above might strike you as a very pessimistic perspective.  Allow me to disagree.

It’s tough to go through life without setbacks.  Bad things can and do happen, to good people.

The good news, of course, is that the list of catastrophic risks you will face in your life is pretty short.

Instead of avoiding them, acknowledge them.  Run a pre-mortem on your financial situation.  Hedge the downside.

And once you are done, you can focus on the upside – with a clear, peaceful mind.  Trust me, it feels great.

As always, thank you for reading.

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16 Comments

    • Hah, the joys of doing business in emerging markets!

      I’ve got a few friends who built up their careers constantly travelling around emerging economies in places like Africa…. was always a stretch too far for me on account of safety, but they treated it as an adventure.

  1. Protect the downside has always been my mantra. There’s an argument that sometimes stops me taking some risks worth taking though.I’ve also realised most people just don’t think like this
    We’ve been thinking about moving for a while and I analyse all the things that could go wrong
    More stress of a bigger mortgage
    If I lost my job not being able to get the same salary again and having to sell
    My dad and step mum’s pov is well you can just sell the house again if it happens. I see their point and they’re probably right but there’s also comfort that they don’t understand that if I lost my job now we could afford where we are quite comfortably for a number of years and even a new job on minimal earnings. I’m not really sure what the right pov is to be honest or if there even is one

    • Well that attitude is not entirely surprising coming from an insurance broker!

      As Trump used to say, “Protect the downside and the upside will take care of itself”

      Sure, there’s always a way to limit the impact of any unfortunate curveballs but I’d rather avoid them in the first place.

  2. This is all reason why I’ve always had quite a large cash cushion. To not only allow me to invest more aggressively in the stock market (with high equity allocations), but to hedge against unforeseen life events. To me, having two years of cash in the bank will make anyone sleep better (even with high inflation). That is the best way to protect your downside iMO. Cheers!

    • I’m in the same boat and also keep an extra cushion to insulate from any short term cash needs in our rental property portfolio.

      Interestingly enough when I retire early (if I ever do), I am probably going to target 2x living expenses in cash as well. Just something very peaceful about having your annual budget sitting in your bank account at the start of the year, leaving you to focus on going about your business.

  3. As an American in Europe I am interested where/how you found the best life insurance for what I assume is a multi million coverage amount. US insurers seem to offer much better rates but open only to residents,

    • I actually didn’t shop around and simply went with the option offered through my employer (a bulge bracket bank)

      There’s an option to pick a multiple of your salary (anywhere between 2x and 12x). I went with the option that covers me for about £1.7m, which (when combined with our other assets) would allow my wife to leave her job and focus on bringing the kids up.

  4. Does your life insurance cover your spouse to the same extent it covers you? If not that seems to be the real risk. If you die – pay out. But if your spouse dies – no pay out and then you need to likely quit your lucrative source of cash to support two children (at this point some fool might say…yeah but you just get a nanny). Main risk if you die is that post massive pay out some leech takes advantage of your emotionally knackered spouse and manages to extricate the cash. I haven’t really figured out how to hedge that downside beyond having the conversation with said spouse. You can put such money in trust for children but it’s a bit painful in the UK to do so I think. You did say hedge the downside….

    Also if you want to hedge the downside then I can’t really figure out why you wouldn’t hold at least some ($TIPS) bonds and gold in physical form. I’ve got about six years expenditure which is circa 10% of net wealth in such instruments, which may prove to be some kind of hedge if the sh*t hits the fan. Yes you are missing out on some upside but this is about hedging the downside right? Or some kind of other real assets.

    I feel fairly well hedged financially. For example if a govt comes in and slaps a 50% CGT rate given UK public services are in the crapper, the plan will be just to not sell anything whilst a UK resident. Be short sterling (or indeed dollars) and long real assets to hedge against continual currency debasement. Equities are in global indices so somewhat diversified from country risk albeit in a crisis all equity correlations go to one don’t they.

    There feels in the UK (kind of less so than the US) a reasonably material risk that in the next five years there is some kind of societal issue (the 2011 riots perhaps being a possible prelude). I haven’t really figured out how to hedge that beyond finding somewhere to pull up the drawbridge which is a bit beyond my means. And I am only speculating but there increasingly seem to be the ingredients in the UK for a lot of seriously upset people in the coming years.

    I would love to be living somewhere that enabled me to be a bit less reliant on third parties (e.g energy providers) and a bit more self sufficient but again somewhat impractical currently particularly in the UK given high house prices. Seems much more achievable in the US potentially. This may all sound a bit preppy which it isn’t meant to be. More of a hedge against living cost increases.

    So yeah I feel pretty exposed here. The pandemic I think also showed that with an existential crisis you can’t really hide.

    • Yeah, excellent point re: spouse. My wife has her own life insurance through her bank, the coverage is solid but come to think of it, not as big as my policy. Time to re-evaluate during the upcoming annual enrolment window.

      We keep a very big chunk of our net worth in cash as well, think there’s possibly some juice to be squeezed out by transferring it in TIPS though I guess those only protect you if inflation comes in above expectations (as current projections are already priced in)

      To me, the pandemic showed that you really want to live in a country with a good healthcare system. Or, at least, have the option of coming to that country on pretty short notice….

      • mmm catastrophe suggests wheels coming off somewhere in an unforeseen way in which case inflation linked bonds and physical gold is likely to cover more bases I feel. Except rising interest rates in which case cash is indeed going to be helpful hence why it’s worth carrying some not withstanding the negative drag. All in thats probably sub optimal and clearly I am largely pointed towards continued growth…at least nominal.

  5. To add a couple of points to the list of terrible outcomes one should worry about:
    1 – Fraud/ scams resulting in catastrophic loss of capital
    2 – Litigation resulting in major damages owing to the other party

    I’ve seen families ruined by both.

    • Yes great points.

      And whether we like it or not, we become ever more exposed to #1 as we age and experience cognitive decline

  6. I think protecting against downside and/or total ruin in anything we do is crucially important.

    The main logical thinking the masses have is that they’re overly optimistic. “Black swan” events are defined as rare events that happen but have extreme downside. But as rare as an event is *at any given point in time*, they’re quite frequent, and perhaps, inevitable over the long-term. The illusion that very bad things won’t happen EVER, because they haven’t happened yet leaves a lot of us unprepared, I feel.

    But in life, and in business, there’s always some crazy threat that you need to address before it happens. Layoffs happen more frequently than we think. A good business can get priced out as long as there’s a competitor that comes in and can execute better. Millions saved over decades can be lost with one bad trade. An unconscious habit of eating too much unhealthy foods / not exercising enough can lead to heart disease.

    It takes active proactivity to fend off as many of these hidden threats as possible. And even then…there’s probably still some unforeseen thing that’ll happen. But hopefully it won’t be as bad if we’re somewhat prepared for it.

  7. @nomad

    My understanding is that uk and USA life markets are different. In the Uk rates are generally fixed for the term of the cover eg whole of life means exactly that with fixed premiums for life. Similarly for term insurance (ie 10,20, 30 years)

    Some American cover seems to be heavily discounted for the first x years and then is reviewable – obviously upwards and sometimes massively if health status changes…

    Employer life covers is subsidised in Uk – and pretty generous usually.

    Interesting fact – virtually all Life companies reinsure their life risk, they are all mostly administrators..

    boltt

    • Indeed. I get my life insurance through my employer and the policy costs a pittance, especially given the coverage amount.

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