Different ways of looking at risk

Designing good financial defences

Defending against the wrong threat 

By building the 'Maginot Line' between the wars France invested heavily in its future security. Heavily, but not cleverly...

This line of forts was so strong that the French thought they would repel any future German invasion from the east.  In a sense they were right, because Hitler didn’t take it on.  Instead he blasted through Belgium, and Paris was taken in a few weeks by an attack not from the east but from the north.  The Maginot line held out magnificently unscathed, but entirely irrelevant.

Private financial defences

A large global business - the insurance industry - now sells us our own financial safety, and most of us seek some personal financial security through it.  We build our own line of forts, to secure ourselves and our families against future financial onslaughts from, for example:

• Premature death
• Becoming permanently unemployable
• Having a house destroyed
• Huge medical expenses
• Being found liable for huge damages by a court of law (e.g. after a car accident)

But are our forts in the right places?  How many wealthy people could identify a risk which is statistically many times more likely than the listed disasters, which would be financially ruinous, and which is widely uninsured?  Probably no more than 1 in 10 could identify the risk.  Probably less than one in 10,000 has covered it.

Systemic failure

The risk is loss arising from the collapse of a large part of the financial system - a currency say, or a global banking crisis brought on by a derivative collapse.  The forts of peoples’ private insurance arrangements has been built.  But the most likely case is that their financial destruction is threatened not from the east, through the relatively improbable and isolated disasters which befall individual men and women, but from the north, from where comes periodically the cold wind of general financial chaos, destroying almost everyone’s finances at the same time.

When instead of being private the disaster is public, and financial, the number of victims can easily grow by a thousand times, or even a million.  The UK's Lloyds of London debacle ruined tens of thousands of Britain’s wealthy.  The Argentinian collapse ruined millions of scrupulous and trusting savers, as did the stock market crash of the early seventies, and the bursting of the worldwide dotcom bubble at the end of the nineties.  Meanwhile the Great Depression wiped out the financial fortunes of tens of millions of industrious and successful citizens of the world.  

Nothing like these numbers of wealthy people have ever been affected by all the insured premature deaths, house fires, personal injuries or liability claims of the twentieth century put together.  Yet all these financial disasters, and many more like them, have occurred within the last 100 years.

The fact is that big financial crises are really quite common, and the seed-corn of these accidents is that the victims suffer a collective memory failure which sets up the circumstances.  Typical is the way the population of the western world ignores trade and budget deficits spiralling to ever more unsustainable levels, and tolerates outstanding derivative credit within financial corporations which already exceeds $300 trillion (about $250,000 for every man, woman and child in the developed world).

Against this backdrop most wealthy people have secured their accumulated capital with a nice house, and put a small surplus invested in deposits, stocks, bonds, mutuals, property, or whatever else their private investment preference dictates.  Put together these investments yield a few percent of their current annual outgoings.

All of this wealth is at risk in a general financial crisis. In a financial collapse almost nothing can be sold. Profits fall. Dividends are cut. Banks cannot pay back depositors and government deposit guarantees become hyperinflationary and are worthless. This happens in at least 1% of years, ordinarily in circumstances not so dissimilar to those around us now.

Beating systemic failure

Fortunately the insurance needed to defend against that type of problem is just about the cheapest form of insurance it is possible to buy.  The reason for this is because - necessarily - it does not involve any insurance companies or other financial organisations. In a world of financial crisis gold bullion held legally and offshore regularly holds and multiplies its value.

This is why people are buying gold. You can already see in its price that growing numbers are re-discovering the painful lessons of history.