A few days ago, I received an interesting email from someone who finds himself worrying about the effect of catastrophic events on his investments. The writer says that the basic theme of my investing advice is always to invest gradually over the long-term. What worries him is the possibility of catastrophic events like a global depression or a war that suddenly wipes out carefully accumulated wealth. He'd like to know what one can do to protect one's nest egg against such disasters.
This worry is justified. There have been few parts of the world that have not gone through the twentieth century without a major economic-political-social dislocation. We can't just assume that our lives will pass without anything like that happening. In fact the world seems especially ripe for a wide-ranging catastrophe. From nuclear terrorism to peak oil to disastrous climate-change, you can pick a favourite one from a choice of catastrophes. By the way, that phrase, 'A Choice of Catastrophes', is the title of an interesting book that Isaac Asimov wrote on a somewhat related topic.
Is there a way to guard once financial well-being through such events? The classic way of guarding against adverse circumstances is something that any investor should be doing anyway, which is diversification coupled with a sensible asset allocation. The basic idea of diversification is always that every kind of investment doesn't do badly simultaneously. One should spread one's investment across different kinds of assets (stocks, fixed income, gold, real estate, bank deposits etc) as well as different industries and different parts of the world. Closely coupled with this are the ideas of booking profits and reallocating investments between different investments.
Asset reallocation means that as the riskier (and hopefully higher return) investments make money, one should keep booking profits in them and putting the money into safer investments so that one never gets over-exposed to excessive risk. Asset reallocation is essentially about maintaining diversification. An example would be someone who keeps 70 per cent of his money in stocks and 30 per cent in bank FDs. Whenever, stocks are earning more and their 70 per cent share rises, the investor shifts some money into the FDs to restore the percentage.
Can such a simple method actually protect against catastrophes. I think it can protect against most catastrophes. Of course, the word 'protect' here is relative. If the world economy goes into a deep depression, then your investments are going to fall in value. With proper diversification, they'll fall less, hopefully a lot less than they would have otherwise. If you've invested gradually into well-chosen investments, then hopefully you would have gained enough already and the fall would only reduce your returns rather than eat into your capital.
However, there are no guarantees. The only way to be perfectly insulated from an investment crash is to not invest. If you want to participate in the rewards of an investment, you must participate in its risks also. That is a given. I don't think there's any investment strategy that's going to help you against the severest catastrophes. I mean holding 'safe' investments like RBI bonds, bank FDs and cash funds may not be of too much real help if the Pakistanis nuke Mumbai and Delhi. However, I think less severe catastrophes can be guarded against by following the same simple strategies that you should be following anyway.