New Year risk analysis for your portfolio

Paul Tustain - Tue 03 Jan, 2006

"...The Maginot line held out against the Nazis unscathed, but entirely irrelevant. Today a large global business - the insurance industry - now sells us our own safety. Most of us seek some personal financial security through it. But are our forts in the right places?..."

By building the 'Maginot Line' France invested very heavily, if not very cleverly, in its future security.

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.

Today a large global business - the insurance industry - now sells us our own safety, and most of us seek some personal financial security through it. We build our own little 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
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.

The risk arises from the potential collapse of a large part of the financial system. The Maginot line 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, which destroys almost everyone’s finances at the same time.

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 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 victims suffering 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.

That's about $250,000 for every man, woman and child in the developed world.

Against this backdrop look at how most wealthy people have secured their accumulated capital. They have already bought a nice house, and their surplus is invested in deposits, stocks, bonds, mutual funds, property, or whatever else their private investment preference dictates. Together they yield a few percent of their current annual outgoings. And 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.

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 today. You can already see in its price that growing numbers are re-discovering the painful lessons of history.