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Assets for rainy days

Hans-Joachim Voth argues (in German) that the problem with investing in stocks is that when you most want to sell them, you can’t, as financial markets are often “closed” during wars and great economic crises.

So, if not stocks, what else should people put in their rainy day fund?

Nassim Taleb recommends in the “The Black Swan” to follow a “convex” investment strategy: Hold 85 to 90 percent in the most safe assets (such as US government bonds) and the rest in “venture capital-style portfolios” (p205).

But why should the stock prices of risky firms rise during economic catastrophes? They are risky because their business model is speculative, not because they do well in bad times.

Then there’s Kim Oosterlinck who shows (ungated here) that in occupied France during World War 2 small artworks outperformed other assets such as gold, equities, bonds or foreign currencies. He argues that usually such items are “conspicuous consumption”, so they are valued for the bragging rights they come with. But in bad times the fact that they can be transported and sold discreetly is more important.

Nouriel Roubini has to say on this topic:

If you worry about financial Armageddon, it is indeed metaphorically the time to stock your bunker with guns, ammunition, canned food and gold bars.

Taken literally, it would be a bad idea to save like that.

The problem is that we’re not good at dealing with low probability events. Usually we just ignore them and when we do think about them we fixate on some particular kind of catastrophe.

For example, when the nuclear disaster of Fukushima happened, the conversation turned to whether one should take precautions in case a radiation emergency occured in Europe. When there was a major power outage in the North of Germany, people talked about how it was necessary to keep sacks of potatoes at home.

But any such scenario is really unlikely. If you still want to be prepared for them, you should try to come up with a reasonable estimate for how likely each scenario is and then rationally account for them all depending on their relative likelihood. It’s a bit like “moral licensing” for altruism: We spend all our “panic capital” on one scenario and then assume we’ve done enough and don’t think about all others.

So say you’ve bought your potassium iodide tablets, you’ve stored your 14 days (German) of food at home and you keep your Krugerrands hidden away. You then hopefully realize that most investors, most of the time, should keep the majority of their free wealth in a low-cost portfolio of global stocks and bonds.

And – most importantly – the bulk of risks that people face are idiosyncratic, so they’re specific to an individual. You might fall seriously ill, loose your job or there could be a fire in your home. But the fallout from such cases is best mitigated with classical insurance rather than some specific asset.