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Should You Hedge Against Natural Disasters?

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Note: This article is an attempt to quantify the investment impact of natural disasters. It is not meant to minimize the terrible emotional and financial toll they take on of those directly affected, or downplay the devastating loss of life which occurred, and will happen again in future disasters. 

 

Last summer the New Yorker published an article titled “The Reclip_image001.jpgally Big One.” Since then we’ve received the occasional question on the topic on natural disasters. Most questions are some version of how would “The Big One” affect my portfolio? Or should we hedge against these types of events? 

So, I decided to run the numbers. While there is no way of knowing the impact of a specific disaster—particularly, as New Yorker article alludes to, one that’s different (i.e., worse) than those in recent history—looking at how the markets have reacted to past events is informative. I acknowledge that if the entire Pacific NW region slides into the Pacific Ocean the markets may react differently than they have in past disasters. However, this isn’t something worth planning on happening and certainly not in crafting an investment strategy around. 

So, the rest of this article is organized as follows:

  • a review of the market's reactions to several different natural disasters,
  • an assessment of if it makes sense to hedge these events,
  • and then a look at the business processes we have in place to deal with a natural disaster.

What impact does a disaster have on my investments? 

Using data from the Wall Street Journal, I looked at the ten costliest natural disasters in US history. And, on average, the US stock market return was positive over the next week, quarter and year. The largest negative return came after the October 2008 Hurricane Wilma—it's safe to say this negative return was driven more by the financial crises than it was a response to the hurricane. 

Overall, the S&P 500 was up 0.7%, 0.6% and 5.9% on average over 1-week, 1-quarter, and 1-year following these events respectively.  And the relationship between the magnitude of the disaster (measured in dollars) and equity returns is about as close to zero as you can get (see r-squared in the table below).clip_image003-1.jpg 

 

Next, because most of the ten costliest US disasters are quite recent (and US specific), I selected a few other disasters to analyze. I kept the three most expensive US disasters and added the 1989 "World Series" earthquake, the 2011 Japanese earthquake and tsunami and the 2004 Boxing Day Indonesian Earthquake and tsunami. Again, as you can see in the chart, there is no clear pattern of markets selling off and ringing up massive losses after these terrible natural disasters.Natural_Disasters4.png

 

Should you hedge? 

So, the next question is, does it make sense to hedge these types of events? 

Hedging, or insurance, is used for two things—to spread risk across a wide population, and (or) to protect against an "unrecoverable" loss. For this, the seller of insurance is expected to earn a profit—i.e., it costs you money to hedge. 

As it relates to natural disasters, do we want to spread the risk of a regional specific economic disaster? Yes, but this is done via diversification. One company or region may be impacted, but a properly diversified portfolio is going to own many different companies throughout the US and the world. Diversification, as the saying goes, is the only free lunch in investing. It reduces risk and increases, on average, your expected return. 

Hedging (or buying insurance) on the other hand actually costs you money. It is best used to protect against a loss, so devastating, from which one could not recover. Think home owner's insurance. For most people, a fire which destroyed their home (but not their mortgage) would be an irreparable loss. But the data doesn't suggest natural disasters have a meaningful impact on investment returns. In other words, it’s risk one can afford to take.

What should be done from a business and access standpoint?

Even if the investment impact of a disaster doesn’t merit hedging, one should still have a plan in place to deal with disaster should it strike. Here’s a quick summary of what we convey to our clients:

  • We have a Business Contingency Plan in place. Our plan outlines the protocol for both short-term and long-term disruptions of access to our primary place of business—employees working remotely, an identified alternative location and maintenance of critical system are all part of the BCP.
  • We are cloud-based. Most of our critical systems (client documents, CRM, trading platform, etc.) are cloud based. As long as we can connect to the internet we will have access to our systems.
  • We don't custody your assets. Most of our clients’ custody their assets with Charles Schwab and Schwab has teams in both Denver and Phoenix. Should for some reason you can't reach us (or we can't access the web), you would still be able to access your assets, either online yourself or by contacting Schwab directly.

 

The bottom line is that as terrible as these natural disasters are, one shouldn’t create an investment strategy based on a prediction of when the “really big one” will strike. Have a plan in place, yes. But don’t hedge.

 

 

Intel Employees – To learn more about building a smart, diversified investment strategy and how to get more out of your Intel Retirement accounts without hedging, join us for an upcoming education event. New Call-to-action

 

 

Click here for disclosures regarding information contained in blog postings.
Cordant, Inc. is not affiliated or associated with, or endorsed by, Intel.

Published on March 14, 2016

Isaac Presley, CFA

Isaac Presley, CFA

Isaac Presley is Director of Investments for Cordant, a wealth management firm serving current and former Intel employees. To learn more, you can read Isaac's full bio.

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