Extreme Risks – summary paper – 2013

The summary ranks the top 15 extreme risks impacting economic growth and asset returns, under the categories of: financial, economic, political, environmental, social and technological.

How should investment institutions actually adapt in recognition of extreme risks? We would suggest a prioritisation exercise: first, worry about the events ‘that can kill you’ – that is, permanently impair the investor’s mission. This should identify which extreme risks matter and which can be ignored. For the former, the right thing to do is to pay up for the insurance, given that the prioritisation exercise has shown the investor cannot afford to self-insure. Second, an investor should do the simple things. These would include ensuring the portfolio is as diversified across as many return drivers as possible; diversifying within asset classes; and creating a strategic allocation to cash to provide optionality. Finally, greater complexity can be added over time, assuming it passes a considered cost/benefit analysis. This is likely to involve adding long-dated derivative contracts in a contrarian manner – that is, when they are cheap rather than popular.