PrintYesterday, 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 advisor 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 looked 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.
Defcon 1 – The U.S. today: economic uncertainty and looming hazards
Conditions: Where we were in the U.S. 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 being back into stability. I believe that’s exactly where we’re now headed in the U.S., but the other course is also possible. Since 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 which direction the situation is likely to evolve, a widely diversified portfolio is the best approach to prepare for Defcon 2, 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 assets like gold and real estate.
Defcon 2 – Europe today: widening financial uncertainty and social stress
Conditions: An evolution of Defcon 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 Defcon 1 but with rising risks) and Greece at the other end (approaching Defcon 4). The social infrastructure has started to decay in many countries, with Spanish and Italian unemployment 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 outlined above, 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.
Defcon 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, as no institution would trade with others 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 percent and government bonds up 50 percent, down 45 percent, and finally down about 9 percent 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, tactical strategies designed to go to cash, and the like. In times of financial stress, gold has historically been a good store of value. Real estate can directly protect against inflation and currency depreciation, as rising construction costs provide a competitive moat for existing properties.
Defcon 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 the money, you want a ranch in the rural West with very few neighbors, its own water source, fields, and livestock, and a solar generation system for electricity. You’ll need all of that, as 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, as most areas 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 Defcon 5 scenario, most people will simply die, and the remainder will revert to a less ordered society. Worrying about financial assets will be pointless, as 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 impact the whole world in the same way. An Asian investor would have benefited from holding dollars during the Asian financial crisis, for example, and an Icelander from holding euros and gold in 2008. While 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 until systems recovered enough to take us back to Defcon 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 Defcon 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.
