The Disaster Playbook for Investors

The disaster playbook is a well-thumbed document these days as investors try to make money in the wake of the disaster in northern Japan. The typical sequence of events in any disaster begins with sheer panic, followed by predictions of utter chaos, spooking financial markets and causing prices to plummet.

Eventually the panic subsides and it becomes clear that the impact on the global economy is slight. The playbook tells the investor to buy while there's blood on the floor and profit from the market's overreaction.

The evidence to support the playbook is strong. The man-made disaster of the October 1987 market crash created overwhelming fear in the investing public, yet buyers of the DJIA the day following the crash received an 11.5% return after just 22 days. After 9/11 buyers got a 13.4% gain in the 22 days after markets reopened.

Hurricane Katrina was the costliest natural disaster in U.S. history yet buyers of the DJIA on August 30th, the day after the levees broke, gained 2.6% over the next eight days. This pattern is not anomalous; Ned Davis Research studied the results of 50 calamitous events going back to the panic of 1907 and found that investors who bought into the panic gained an average of 3.7% after one month, 9.0% after six months, and 14% after a year.

The hitch in following the playbook is the remote-but real-possibility of a "Black Swan" event that carries with it consequences that the market could not foresee. The 2008 financial crisis may be the best-known example of a Black Swan event. Not only was the event extraordinary and difficult to forecast, but the outcome was completely unexpected and nearly cataclysmic. Not even the speculators who made fortunes betting against mortgage-backed-securities predicted the near-total collapse of global credit.

But in hindsight even the financial crisis didn't seem to warrant the fear we normally ascribe to a Black Swan. The financial crisis is the only event that had negative returns in all four of the time periods covered in the Ned Davis study, but the S&P 500 Index did return to its pre-crisis level after a year and a half.

Would a meltdown of nuclear reactors in Japan constitute a Black Swan event? Thus far, the financial markets have behaved the same as during other calamities, with markets around the world sharply falling during the first few days of the event before bouncing back. The 16% decline in Japanese stock indices may be a classic case of investors overreacting; once again, objective and professional risk takers are acting as contrarian investors to take shares from weaker hands.

However, it isn't clear that the playbook actually extends to nuclear meltdowns. The risk of a meltdown may be smaller than it was several days ago but its consequences might be impossible to quantify. The world has never seen radioactivity threaten one of the world's largest economies; investors can study Three Mile Island and Chernobyl as much as they wish, but they don't have enough information to do their job based on facts. They only have the playbook.

Steely-eyed risk takers who follow the playbook evaluate risks in the context of sensible portfolios that are broadly diversified across different asset classes and bereft of leverage as well as dangerously large allocations to any one individual stock in the portfolio. Ultimately, a true black swan event is impossible to fully diversify against: the only consolation is that its effect on the markets will be mercifully brief.