You may have a portfolio with a mix of asset classes and geographic distribution. You may even hold tail risk products that deliver upside in the event of a market correction. But does the portfolio carry any protection from the greatest risk of all – institutional collapse?
Systemic market failure was triggered on 15th September 2008 with the collapse of Lehman Brothers calling for massive bailouts. Eleven years later the Fed and central banks around the world still cannot find a way to restore order. Their only remedy is the further expansion of money supply – a strategy that can only have one ending.
Let us be honest with ourselves for a moment. If the institutions required to realize the value of assets held in your portfolio disappear, what is its residual value? I said be honest. What percentage of the portfolio still holds value? Probably not very much which is why it takes guts even to ask the question.
Banks, insurers, exchanges, brokers and clearing houses are so inter-dependent that the failure of any can create a cascade of insolvency throughout the system. The trigger can come from anywhere. In the words of Steve Eisman, one of the few that saw the 2008 crisis coming, the risk is unlimited. Student debt, lack of liquidity in VIX and attacks on Saudi Arabia are a few of the current hot spots. According to Donald Amstrad of Aberdeen Standard Investments, governments may no longer have the capacity for another bailout.
Most investors don’t face up to the risk of institutional collapse for a number of reasons:
· It’s too big a problem for me to contemplate.
· No one else is facing up to the problem so why should I?
· I’m going to look stupid if I start talking about this to anyone else.
· There is nothing I can do about it anyway.
According to the Swiss-American psychiatrist Elisabeth Kübler-Ross there are 5 stages to grieving: denial, anger, bargaining, depression and acceptance. It may be worth checking to see which stage best describes your current position relative to the systemic institutional risk carried by your portfolio. Is there any movement beyond denial? The fact is in most cases the fragility of the financial system IS the fragility of the portfolio. Did I mention the need for honesty?
If the reality of institutional risk has begun to dawn on you the most empowering thing you can do is to realise that you can do something about it. Remember the portfolio is either your own money or you are paid to manage that money on behalf of others.
On the face of it the solution is simple: hold assets which are valued in themselves i.e. assets that are not derivatives and do not depend on institutional counter parties to realise their value. The list of contenders is short but clear:
· Property, owned outright to avoid dependencies on banks.
· Commodities, including precious metals, again owned outright and preferably physically held.
· Digital currencies such as Litecoin, Monero and Bitcoin – non-collateralised assets whose ownership is recorded on a distributed ledger requiring no third party to access.
I developed SMIs specifically to increase the number of assets that diversify away from the greatest risk of our time. I do not pretend that SMI’s are risk free. However the risks they carry pale in comparison to the enormity of the risk built into most portfolios because of their dependence on financial institutions to realise their assets’ value.
At heart we are dealing with a design issue but I do not want you to take my word for this. After all I have a vested interest in promoting Bitcoin Enhanced as the first example of an SMI.
Instead look at the way Google delivers their business.
The one essential for Google’s business is for its services to be available. Any outage could be catastrophic. So in order to avoid this unacceptable risk Google has servers in farms scattered around the planet. Each server is independent of other servers even though they share the workload. This independence means that if one server fails – which often happens - service is not interrupted as the other servers take over the tasks.
This is what a diversified portfolio is supposed to look like. If one asset fails to perform the returns of the portfolio are delivered by the remaining assets. This can only happen if the value of the assets is independent of each other and any other dependencies.
The problem is that the vast majority of assets in a portfolio are likely to depend upon financial institutions to realise their value. As these institutions are mutually dependent upon each other for their solvency we are in fact dealing with just one system. It is a single point of failure. Google would never run its business with a single super-computer. The risk of catastrophic failure presented by the design would be intolerable. Yet this is exactly the situation most portfolios find themselves in today. If you manage a portfolio perhaps you need to ask yourself “If Google wouldn’t tolerate this situation why do I?”
The moral – the Titanic was so huge nobody through it could sink. When disaster struck there were not enough lifeboats to go round.
A portfolio can be diversified away from its greatest risk, but the options are limited and the first step is to acknowledge the problem.