Investors must prepare for the unexpected

I didn’t think too much about it.

“Could you do me a favour?”, she asked.

“Yes”, I replied obediently.

I was in my early twenties and I was new to the job. So, I would say “yes” to pretty much anything.

The novelty of wearing a suit and tie to work hadn’t quite worn off. I was working at HSBC, which was at the time, the world’s largest bank. It’s fair to say that I was feeling pretty proud of myself.

“Can I borrow your security pass?” she asked. “I left mine on my desk and I really need the toilet”.

 “Um…. Sure!” I replied.

“Thanks”, she said snatching the security pass from my hand.

She flew through the security doors with my pass and disappeared. And that was that!

Fifteen minutes later and we all received a group-wide email. It was from HSBC’s security team:

“Mr Eagle, could you please come down to the security office. We found your security pass in the women’s toilets”.

I endured months of teasing.

It doesn’t matter how well you research a company or analyse its financials, the unexpected will occur.

Corona virus in China is a classic example. It was completely unpredictable. One unusual fallout was Corona the beer: Google search has a seen a 3,200% pick up in the phrase "beer coronavirus". Though it too early to draw any conclusions, the next earnings report from Constellation Brand – the brand owner of Corona beer – will be interesting to read.

These things happen. I remember switching on the TV and watching a jetliner fly into the World Trade Centre. It happened!

Most of us will experience these dramatic events in our lives, yet we often think of them as highly improbable before they occurred. The problem is that we’re not wired correctly to adapt. We are emotional beings and this influences and distorts our intuition about risk.

The problem is these random events happen with a frighteningly regularity. And, statistical philosopher Nassim Taleb, refers to them as black swan events.

What is a black swan?

Blacks swans are something that are considered impossible until they occurs. For instance, a couple of hundred years ago, black swans didn’t exist. All swans were white. That was until black swans were discovered in Australia.

Losing my security badge in the ladies’ toilets is no different. When I woke up that morning to get ready for work, this event was incomprehensible.

This is the problem investors face today. Stock markets have risen tremendously over the last decade: equity markets have reached all-time highs in the US, while multi-year highs have been achieved in Europe. This has led investors to cast aside the need to diversify, manage risk or even actively invest.

We can’t assume stock markets are overvalued

This doesn’t mean stock markets are overvalued. Warren Buffett for instance has said that equities are a huge bargain if interest rates remain where they are: money doesn't cost anything and we are at full employment and no inflation.

But that’s not to say things are normal.

Apple for instance, has a market cap that is now greater than Germany’s top 30 companies. In fact, it’s great than the entire market cap of Australia’s stock market.

Meanwhile Tesla’s market cap has surged past Volkswagen, making it the second largest auto-manufacturer in the world. This despite it only produce 367,000 vehicles in 2019 versus the 11 million produced by Volkswagen.

Admittedly, both companies are highly successful. They stunned the investment community with their latest fourth-quarter earnings reports. Yet the valuations both companies have achieved are still extraordinary. They can’t simply be explained away with where interest rates are.

Technology stocks in the US now dominate the market in terms of market cap. Again, this doesn’t necessarily indicate overvaluation. Our global economy is set to undergo dramatic changes and experience significant disruptions in the decades to come. We are after all, at the dawn of a digital age and low carbon economy. The valuations tech stocks have achieved could well be rational – we just don’t know for certain.

It’s time for investors to be more active

We are nonetheless, at the beginning of a new decade with high stock market valuations, record levels of debt and growing geopolitical instability. For investors, this is not the time to be complacent. They need to be more active.

The different risks that they are exposed to, will need to be balanced out and diversified away. They will also need to improve their risk-return profiles and look for new sources of risk-premia to enhance returns. Even if the unexpected happens, doing these things will bring stability to their portfolios during times of crisis.

They should, however, start preparing now.