I was playing golf the day after the Japanese earthquake and tsunami.  A fellow golfer and non-client asked me:  "Les, what should I do with my portfolio now that the tsunami has hit?"

 

I told him respectfully that the time to deal with potential calamities is before they hit, not after.  And, later, as we sat at the 19^th hole, we discussed Black Swans and the need for portfolio review.

 

Even now, two weeks after the crisis, we still don't know the full extent of the damage from the tsunami that hit Japan on March 11^th.    Obviously, the first focus was on preserving human life.  The early estimates of the economic damage are huge:  perhaps $200 or $300 billion.   This disaster might push Japan's economy, already deep in red ink and close to recession, into deeper problems.  And, we haven't even discussed the potential of a nuclear catastrophe, which hopefully has been stabilized.

 

Japan's Nikkei 225-Stock Average lost 17% in the two days after the disaster struck.  The Bank of Japan was forced to pump record amounts of liquidity into the financial system to prevent a collapse.  The yen soared as Japanese institutions brought home money to deal with the crisis.   Worldwide, uncertainty caused panic selling at first and then the markets rebounded.

 

Certainly, tsunamis are unpredictable.  Some would call it a "Black Swan" event.  Nassim Taleb, author and market guru, popularized that term in his 2007 best seller.  Mr. Taleb outlined three characteristics of a Black Swan.  First, it is unpredictable. Second, it carries a massive impact. And, three, after the fact "we concoct an explanation to make it appear less random, and more predictable, than it was."    These days, black swans seem to occur far more regularly than most people believe.

 

Just look at some examples of major Black Swan events over the last decade:  911 attacks at the World Trade Center, 78% decline in the NASDAQ, 2003 European Heat Wave (with 40,000 deaths), 2004 Tsunami in Indonesia (230,000 deaths), 2005 Kashmir earthquake (80,000 deaths), 2008 Myanmar cyclone (140,000 deaths), 2008 Sichuan, China earthquake (68,000 deaths),  failure of Lehman Brothers and sale/liquidation of Bear Stearns, 30% drop in house prices, 2010 Haiti earthquake (315,000 deaths), 2010 Russian Heat Wave (56,000 deaths), 2010 BP Oil Spill, 2011 Surge of Unrest in the Middle East, 2011 Japanese Tsunami.

 

Yes, historically, stock markets have a history of withstanding calamities.  Typically, natural disasters, from earthquakes to cyclones, tend to jolt markets but not derail them.  But what happens if a series of Black Swans produce a "Perfect Storm?"  Is your investment portfolio ready for that?

 

We suggest you look at your portfolio before that happens and have your emergency plan in place before things get dicier than they already are.

 

Here are some techniques to consider:

 

1)       Review your overall risk tolerance.  Make sure the risk in your portfolio is commensurate with the level of risk you can or are willing to withstand.

2)      Review your diversification.  Make sure you are adequately exposed and not over -exposed to the various asset classes based upon your unique facts and circumstances.

3)      Review your liquidity.  Make sure you can make changes quickly for the greatest part of your portfolio, if they are needed.

4)      Monitor your portfolio regularly.  "Set it and forget it" will not work these days.  You or your investment adviser should be watching your portfolio regularly and be prepared to make changes if things are figurately and literally melting down.

5)      Consider adding "liquid alternative" funds.  These are liquid mutual funds that follow hedge-fund like strategies.  They were established for the investor seeking less volatility and more absolute-type returns than the equity market.  Liquid alternative funds may include market neutral funds, global allocation funds, arbitrage funds and closed-end specialty funds.  Many of these are designed to perform in any market environment- performing in up markets and protecting in down markets.

6)      Consider hedge funds.  Hedge funds may not be appropriate for many of our readers.  Typically an investor in hedge funds must be "accredited" and the investment typically involves significant risk.  In addition, there can be liquidity and transparency issues as well.  However, hedge funds continue to attract money as many have provided good returns, and most importantly, incorporate strategies that limit the downside risk in the case of market turbulence.

 

Certainly, the disaster in Japan reminds us that the next Black Swan is out there somewhere.  Will your portfolio withstand the next tsunami?  Give us a call if you would like us to help you review this important matter.