The Price of Safety
Updated: May 17, 2022
The University of Cambridge’s Centre for the Study of Existential Risks conducts research in three areas: risks associated with technology and artificial intelligence; climate change and ecosystem collapse; and biological risks.
"The more serious risk is not that governments continue to fail, but that they succeed"
Covid-19, a biological hazard, has caused havoc, but its apparently low mortality rate means it does not present a broad existential threat. So how should we as investors think about serious risks, and what can we do about them?
Risk severity can be thought of in terms of both the probability of an event occurring, and the impact it would have if it did occur.
The idea is that we should be just as concerned with a high probability/low impact event, such as an El Niño weather system, as with a low probability/high impact event, a good example being a Samalas-style volcanic eruption – following the 1257 eruption of Mt Samalas in Indonesia, global temperatures dropped by 2°C, causing widespread famine.
The problem is, while we humans are generally good at gauging the impact of potential shocks, we are not very good at judging probabilities. Sometimes we underestimate them – the probability of two people in a room of 30 having the same birthday is a surprisingly high 71%; and sometimes we overestimate – the chance of a roulette wheel producing 42 consecutive reds is the same as that of two people picking the same single grain of sand from all the world’s beaches.
The upshot is that we tend to either worry too much or not enough.
So-called doomsday preppers are the anchor tenants in the first of these categories, and they must be feeling rather pleased with themselves right now. For those who think there is more to life than baked beans, bottled water, and bunkers, what are the risk mitigation strategies available to them?
Traditionally, the simplest form of portfolio insurance has been to own safe-haven bonds – generally considered to be AAA-rated bonds such as those issued by the US or UK government. These perform well when interest rates and inflation fall, as tends to happen when risks such as the spread of a new and nasty virus or, more broadly, a recession materialise.
Arguably, those with an investment time horizon of 10 years or more should not need insurance, as, following a shock of some sort, things tend to get back to normal at the very worst in a few years.
In other words, there are better things to do with your money, particularly when the costs of insurance – safe-haven bond prices – appear high as they have done for a few years now.
However, we have not been living in normal times. Since the early 1980s, safe-haven bonds have been producing high single digit annual real returns on a consistent basis, way in excess of what should be expected from a low risk investment. This is a function of inflation and long-term real interest rates having fallen progressively over the last 40 years.
Can this persistent decline continue? In the short term, yes; but over the longer term, no. Never in human history has there been the sustained period of deflation that would be required for the high bond returns of recent decades to continue, though the Black Death in the mid-14th century came close.
Inflation is a monetary phenomenon, which means that while governments have failed to produce enough of it in recent years, it is likely they will succeed eventually.
The more serious risk therefore is not that governments continue to fail, but that they succeed. In such an environment, safe-haven bonds would no longer be a risk mitigator.
In fact, declining bond prices would become a risk to be mitigated, and a major one at that. How to do that will be the subject of future columns.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.