Photo: Bloomberg Television
Aswath Damodaran, the legendary NYU finance professor, has a knack for drawing excellent comparisons between current events and the markets. A month ago, he used investors’ expectations to demonstrate how investors were either Orioles or Yankees fans.In the aftermath of Hurricane Sandy, he now has some sound advice for dealing with unexpected, disruptive shocks in the market.
History provides little guidance: When there is a disruptive shock (and the storm definitely qualified), it is human nature to use past history to fill in the gaps, even if it does not quite fit. Thus, my neighbours argued that since train service was up and running a couple of days after the storm last year or the terrorist attacks in 9/11, it was likely to be back up after this one too. In financial markets, investors have used the crutch of historical data (equity risk premiums from the past, PE ratios over time) to evaluate when and where to invest these last five years. In both cases, extrapolating the past would have yielded poor predictions.
In this, the professor goes against the notion that “those who do not understand history are doomed to repeat it.” Disruptive shocks are rare – which makes it difficult to use the aftermath of one as a projection for another – a truth Damodaran recognises.
The professor also notes the abundance of incorrect information that is propagated during a catastrophe:
Misinformation fills the news vacuum: In the immediate aftermath of the storm, there was an information vacuum where the power and transportation companies had no useful guidance to customers and rumours filled in the gap. With each macro crisis over the last few years, we have seen the same phenomenon in markets, where rumours of deals made and unmade have moved markets substantially.
Damodaran’s most important insight concerns the need to anticipate external shocks in order to mitigate them:
But it is better to design resilient systems: One reason that this portion of the East Coast was hit so hard by the storm was that it was never designed to withstand it. In particular, large power-dependent houses with finished basements, power stations that are close to the ocean or rivers and overhead power lines are all rich targets for storms like Sandy. If these storms are the new norm, we have to think about building houses that are livable without power (those older houses have lower ceilings, unfinished basements and fireplaces for a reason) and a more defensible power system. In investing we have to think about a similar redesign of how we invest, with dynamic asset allocation (reflecting the constant shifts in the macro environment) and a stock selection process that is less dependent upon rules of thumb (many of which were constructed for a past that no longer applies).
Essentially, the professor is advocating a diverse portfolio that hedges against potential disruptive shocks. For instance, investors with large equity holdings and no gold could be crippled if the US dollar plummets – those with plans for a variety of worst-case scenarios will retain some of their wealth. The crucial takeaway: act before the crisis hits, or suffer the consequences.
Read Professor Damodaran’s full article here.
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