Is an Earthquake More Predictable Than A Financial Disaster?

It was interesting to learn that a natural disaster is more predictable than financial disaster.  With this kind of analysis there is a very good lesson to be learned in this Yahoo Finance article, written by Jack Guttentag in May 2010.   Read the Article (OOPS! Link Dead!) here

In the case of natural disasters, advances in science and technology have allowed for enhanced detection of early warning signs. The author notes that in the case of Mount St. Helens, seismic testing showed early warning signs that led to restrictions on the area and limited the loss of life as a result.

The capacity to do the same for financial disasters is non-existent.  It’s true that some people see pressure mounting in financial markets and are able to escape the fallout. But warning the masses to do the same is difficult because contradicting information or opinion may be just as compelling.

In the author’s words…

Underlying financial disasters, in other words, are malefactors who profit from the activities that lead to disaster, obstruct any efforts to restrict these activities, and attempt to shift the cost of the disaster to others. There is no counterpart in natural disasters.

Contagion theory describes two major drivers contributing to the extent of damage to which victims of a disaster are exposed.

Positive Contagion increases participation in a high-risk activity based on the social influence of other people.  This leads to a much greater negative impact on victims in relation to both financial and natural disasters.

Here’s a good example from the author…

Consider home buyers deciding whether or not to move onto an attractive flood plain that over a long period has averaged a devastating flood every 50 years. The probability that a flood will occur in any one year is thus about 2%. Based on experience over many such situations, we know that after some years pass without a flood, people will begin to move in. The longer the period without a flood, the more people behave as if the likelihood of one has gone down, though there is no rational basis for this belief.

This behavior is reinforced by positive contagion — the fact that some have done it successfully encourages others to follow.

The perceptual bias in the buildup to a financial disaster is even more powerful. Consider mortgage lenders who can make a lot of money writing loans for subprime borrowers so long as home prices continue to rise at a rate that is twice the long-term average. The longer the high rate of appreciation continues, the more lenders jump in the game, as if the longer period increases the likelihood that the price bubble will go on indefinitely. Yet the reality is that the longer the above-normal rate of price appreciation continues, the closer is the date when the bubble must burst. Positive contagion plays a role here, too – WAMU is making a lot of money in this market, why not us?

Contrast Positive Contagion with Negative Contagion:

Negative Contagion causes people to react to a disaster out of fear in an attempt to escape the undesirable consequences. This behavioral characteristic exacerbates damage during financial disasters whereas destruction from natural disasters is limited by nature.

Mr. Guttentag describes it like this:

…positive contagion arises in the buildup to both natural and financial disasters, but negative contagion arises only in connection with financial disasters. The scope of natural disasters – how extensive, widespread and long-lasting they are — is determined by nature, but the scope of financial disasters is expansible through negative contagion. Fear is perhaps the most contagious of human emotions.
A financial disaster involves a loss of confidence in the ability of one or more major players to meet their obligations. In the bank crises that occurred during the 19th century and through the great depression of the 1930s, the loss of confidence was largely limited to commercial banks and their ability to repay depositors. Contagion resulted in bank runs, which could jump from one bank to another, often with little discrimination.
In contrast, runs during the recent crisis involved withdrawals from money market mutual funds holding commercial paper, and refusals by investors to roll over maturing repurchase agreements and commercial paper. All three types of runs were stopped by early and resolute actions by the Federal Reserve. Otherwise, the crisis would have spiraled out of control.

How does this relate to you and your behavior towards appropriate retirement planning?

To some extent, all people have the ability to take action to mitigate the impact of a financial disaster. Whether it’s paying off a mortgage, protecting assets from tax increases and market volatility or securing a source of future guaranteed income, there are options available to protect yourself from an unforeseen crisis.

Several analysts are putting forth compelling data suggesting another crisis is looming. But then again, there is just as compelling information to the contrary.  No one really KNOWS for sure what will happen or when.

The most important thing is to be prepared for what comes, regardless of the timing or the potential extent of the damage. I learned that in my days as a Boy Scout and it’s a lesson as powerful as it simple.

Please, give some thought as to how Contagion Theory has affected your investment experiences in the past.

Hindsight is 20/20- are you taking a focused look back at what you did (or did not do) in prior financial downturns or bubbles?  Are you applying it today?

Likely, we have all bought and paid for some expensive lessons with our nest egg.

Now, I am not advocating trying to time the market, or saying that any particular advisor can avoid all emotion and make winning trades in every market.

Rather, I am advocating that you put in place protective measures to ensure that you are making wise decisions and taking into account appropriate risks.  This is totally individual- no one size fits all, and each situation is different.

When you’re ready to take protective action against the forces you cannot control , call Annuity Straight Talk toll free, send an email or make an appointment.  We stand ready to assist.

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