DIY investor: a game of optimism

 

A few weeks ago I spent a day talking to a group of insurance underwriters who operate in the Lloyd’s market. I’d never met anyone from this world before and, in terms of different ways to think about the challenge of managing our personal financial lives, these were among the most thought-provoking conversations I had had for many months.

Most people mistrust the financial markets and would rather save what they can in a bank. The minority who are prepared to invest their money need to believe, first, that investing is an inherently better way to provide for their future than simply saving, and second, that either they or someone working on their behalf will be able to achieve better returns this way than they would have received from a deposit account.

In other words, to invest you have to be an optimist (or deluded—take your pick) and so believe that the value of your investment will in time go up. If you don’t believe that, why bother? It was the realisation that optimism plays such a fundamental role in the thinking of investors that made the views of the Lloyd’s underwriters so interesting: for them, success depends on looking at the world through the other end of the telescope. Where investors (and especially individuals like me) spend their time thinking about opportunity, insurers concentrate exclusively on what could go wrong and on how to minimise those risks. Investors set out to make money; insurers to avoid doling it out.

When I go back and look at the investments I have made with this distinction in mind, the question I need to ask myself changes. My natural inclination would be to view my portfolio as a series of investment opportunities in different stages of fruition; now it seems more sensible to say that I have taken a series of risks onto my personal balance sheet, all of which involve exposure to possible losses. The question then is whether I have really thought about what those risks are and how great an impact they might have on me.

The underwriters explained that by providing cover they are accepting that a variety of things could go wrong and require them to pay out. Many will be specific to that particular customer; one-off problems, the cost of which will be covered by the pool of premiums that they have collected from all policies of that type. However, their biggest fear is finding that they are exposed to systemic risks that they were not aware of and that can affect many or even all of their customers at once, leading to huge and unexpected losses. A computer bug that causes business interruption at hundreds of companies simultaneously would be an obvious example.

These big, systemic risks are the ones that investors struggle to think about—the huge build-ups of debt that we see in so many places around the world, property price inflation that far outstrips earnings growth, demographic changes that suggest that state pension and healthcare systems are insolvent. These factors and others are all well-known but we allow ourselves to lose sight of them because the risk remains latent for long periods and in the meantime it is easier and more fun to focus on individual companies and opportunities.

But systemic risks are the ones that can devastate whole sectors and whole portfolios, and if these are the ones that trouble insurers most, I need to be paying more attention to them as well. Some risks, of course, are unavoidable, but it might at least help me to remember that one’s default state of mind as an investor is optimism, not realism.