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Y2K and Black Swans: Investing for the Next Crisis

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It was late 1998 and I had traveled across the country to present at a software conference. In the lobby of the hotel was a group handing out literature on the impending “crisis” that would become known as “Y2K” (Year 2000). I hadn’t heard of it, so I began reading.

I could see there was some sensationalism and profiteering going on, from the tone of the headlines. But I figured I’d just read a few paragraphs — enough so I could dismiss the whole thing as bunk. Instead, I found myself drawn in to the concern….

Assessing the Risk

“Y2K” was the moniker for a bug that had been introduced into computer software by programmers since the dawn of the computing age. In the beginning, computer memory and storage space were frightfully expensive, so when dates were stored in the computer, the years were often abbreviated to just the last two digits: “80” for “1980,” for example, to save space. Even as computer prices dropped, the practice continued out of force of habit.

The problem many were fixated on at the end of the 1990’s was this: How would all of those computer programs function once the new millennium dawned? Would “00” be interpreted as 1900, or 2000? Would calculations between dates now result in negative numbers, or division by zero, causing programs to crash or spiral out of control? If not tested and corrected, how would the software that balanced our bank accounts, that managed our power grid, that controlled our air traffic, that orchestrated our military weapons systems, behave after the new year?

Nobody knew for certain, but with nearly every piece of the world’s infrastructure interacting in some way with computer software, some of the predictions were dire. What would happen to our modern society if utilities, transportation, communications, and public safety systems, computers big and small, those that managed our space systems and those that were embedded in our vehicles and appliances all failed at once? We might face a perfect storm of mounting and interacting systems failures.

Some of the forecasts were downright apocalyptic. And they were hard to argue against. If all the software in the world failed together on December 31st, 1999, it would be catastrophic. It could even be the end of the world as we knew it, if we were unable able to bootstrap ourselves back into the 21st century, because our entire technology infrastructure was failing in unison.

We all know now that didn’t happen. But in 1998-1999 the probabilities weren’t so easy to figure. It was very difficult to assess the true risk of the Y2K bug, at first.

Being Prepared

Now, I’m not an alarmist by nature. But, as a Boy Scout, I had learned to “be prepared.” And, as a software engineer my whole career, I knew that Y2K was a real problem — I couldn’t dismiss it out of hand. The bug was widespread and it would cause system failures if uncorrected. In fact, I had probably coded some of those Y2K bugs myself, back in the days when getting programs to run at all was a far greater concern than whether they’d still be running 10 or 20 years hence. So I understood the issue intimately, and I felt some responsibility for responding to it.

The more I researched the problem, the more compelling it became. There was no end to the speculation about what might fail, and what preparations should be taken. Some observers recommended preparing for something like a winter storm — extra flashlight batteries and a bit of food in the pantry. Others warned about being without basic services for months! (I’ll never forget the ads for a years’ supply of freeze-dried food, delivered to your door step, at a cost of thousands of dollars. That’s a lot of dried vegetables!)

Given my awareness of the issue, I tried to take a reasonable path. I reviewed our family’s overall emergency preparedness. We beefed up our camping gear. We added first aid kits and flashlights. We stockpiled a few weeks’ worth of food, water, and fuel. We even held a mock “Y2K” day where we lived in our house with all the utilities shut off for 24 hours.

Most large organizations ultimately took the issue seriously and had teams of programmers working on fixes in the years leading up to the millennium. As 1999 progressed, more and more of them reported that they had reached their milestones and fixed the bug throughout their systems.

Eventually it became clear that the likelihood of widespread systems failure was low, and that the remaining hoopla was just fear-mongering and profiteering. So I tried to keep my response in check. We didn’t relocate to a rural location, didn’t build a survival shelter in our backyard, didn’t move all our investments into cash or gold.

But, in retrospect, I did go overboard. Though I tried to stockpile only useful items that we would consume anyway in the course of our normal lives, I inevitably acquired specialized gear that gathered dust. (Like a full suite of kerosene appliances, eventually sold for pennies on the dollar at a yard sale. Or dehydrated food that we eventually discarded when it went out of date.) By the time it was all over, I had spent fruitless dollars and untold hours on Y2K-related preparations.

Lessons Learned

Was my Y2K response really necessary? Ultimately, no. Was it a waste? Not entirely. I learned some valuable lessons and even made a little money, in the long run….

Ironically, it was during Y2K that I first learned about and invested in gold. This was before gold ETF’s were widespread. There were very high commissions for trading in the yellow metal, and I spent a bundle on transaction costs. Then, in the immediate aftermath of Y2K, the price of gold slumped, and my investments were in a losing position for years. It looked like a stupid investment for a while, another casualty for common sense. But I stubbornly remained a ‘buy-and-hold’ investor, holding onto my gold during its relentless run-up in the following decade.

Patience and persistence won out: Eventually those Y2K-related positions quadrupled in value!

And I learned some other valuable lessons from the Y2K episode. First of all, a “crisis” with a definite arrival date isn’t much of a crisis, in investment terms. If you’re reading about some upcoming event in the papers for months, then don’t expect a big shock to your investments once it transpires. It’s no secret. The ramifications have already been priced into the markets.

It’s the unknown crises ahead that can potentially damage your portfolio. But there may not be much point in worrying about them either. Since nobody knows when they’ll arrive, or what they’ll entail, there isn’t much you can do about them. And the market has bounced back from every historical crisis so far.

The second thing I learned from Y2K was that you can’t go it alone. Even a do-it-yourselfer like me can’t maintain the illusion of independence for long. Sure, I can stockpile a few weeks of supplies, but soon enough I’ll need the help of other human beings for more food, for health care, to maintain my shelter and transportation. The world is more interconnected and more robust than we imagine in our fears. We need each other, and we tend to take care of each other, like it or not.

So, while the future is no doubt filled with dramatic, sometimes frightening, change, the ultimate effects may be muted, because we are all in it together….

Black Swans: Importance of the Highly Improbable

The term “black swan” to connote rarity was first used by Juvenal, a Roman poet active around the start of the 2nd century AD. Juvenal’s phrase was commonly used in 16th century England to imply impossibility. The presumption in the Old World was that all swans must be white, because nobody in the scientific hierarchy there had ever observed differently. So black swans were presumed not to exist.

But then, in 1697, the Dutch explorer Willem de Vlamingh discovered black swans in Western Australia. And the impossible became reality.

The phrase “black swan” has come to represent an event considered highly improbable, or not anticipated at all, that comes to fruition and has a widespread impact. It’s an especially important concept now in investing, which often strives, and fails, to predict the market-changing events of the future.

The concept was explored by author, scholar, and statistician Nassim Nicholas Taleb in his first book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets and further developed in The Black Swan: The Impact of the Highly Improbable.

As Taleb uses the term “Black Swan,” he means an event with three key attributes: (1) it is an outlier — outside the realm of regular expectations; (2) it has an extreme impact on the world; (3) our psychological makeup leads us to concoct explanations for the occurrence after the fact, so that it would have been predictable.

A key message of Taleb’s latter book is that the variables we don’t even know exist (the “unknown unknowns”) drive the most change in society. Some relatively recent Black Swan events include the unprecedented one-day decline of the Dow on Black Monday in October 1987, Russia’s default and the subsequent unraveling of the Long Term Capital Management hedge fund in 1998, the rise of the Internet and the dot-com phenomenon in the late 1990’s, the terrorist attacks of September 11, 2001, and the subprime-mortgage-driven recession of 2008-2009.

Notably, Y2K doesn’t make the list: it wasn’t a surprise, and it never became a crisis.

Preparing for the Unknowable

The investing game is played with one eye on the future. Even those of us not engaged in trying to predict that future, can’t help but wonder about it. How do you protect yourself from unforeseen events — Black Swans? Do you even try? As my experience with Y2K shows, you can invest a great deal of time and energy to avert a crisis that never materializes.

Part of the solution I think, is a realistic assessment of probabilities, along with your own abilities to control them, or not. Some events are highly unlikely to occur, and will leave you with few options if they do. World war, famine, pestilence, widespread anarchy. Is it a good investment of your limited time and money to try preparing for those? Probably not.

Likewise, do we need to prepare for our entire economic system coming unhinged? None of us can survive without the exchange of goods and services. Economic activity can’t really cease while humans continue to exist. Despite our various cultures and political persuasions, the entire planet has a huge vested interest in keeping the economic system functioning. If these facilitating conditions cease to operate, you’ll probably have a lot more serious and pressing concerns than whether your assets are in cash, or gold, or rental property. So, why let an outlier event shape your investment philosophy and cost you in returns?

Placing Bets

Guessing about the future has proven to be a losing game. Yes, there are long-term threats to sustainability, but these will likely take years to play out, with new factors and variables coming into the picture over time.

Markets gyrate. They go down, and they come back up. We know this from history. It’s guaranteed to happen: Only the timing is in question. But you can prosper anyway. I retired at 50, even though I was invested through 1990’s dot-com bust and the 2008-2009 Great Recession. It didn’t matter that the path contained steep ups and downs: It still led me to the summit.

As you prepare for the unknown, ask yourself: Are you placing bets on a single version of the future? Or are you cultivating the ability to survive and prosper under any scenario?

Certain principles stand the test of time: low cost, diversification, flexibility, conservation/savings, mobility/light weight.

Not infrequently, I hear from readers who have moved all their investments into gold, cash, bonds, or some other “conservative” investment du jour. Yet each of these has its own vulnerabilities and may be anything but conservative under certain conditions. They can be blindsided by government policies, hyperinflation, and probably a few Black Swans we have yet to envision….

Ignoring Pundits

Invest your wealth wisely in a diverse set of high-probability, low-risk assets. Don’t let pundits, posers, or politicians lead you astray.

Ignore the extremists on all sides. Accept that you can’t fully predict or prepare for the future. Stay diversified, and invest for the long haul.

A new color of swan may be just over the next horizon. And that’s OK.

Comments

  1. Another great post by straight-talking/ “Straight Arrow” Darrow…the anti-alarmist in a white noise world. As the current bull market tramples on beyond 5 + years, history has shown that some type of correction is likely. It’s how we respond to it that ultimately matters.

  2. I have been reading your blog for quite some time and find it very useful, particularly your opinions on retirement calculators. I have purchased PRC and it is great to look at how different variables effect outcomes. After reading Y2k and black swans and using the PRC calculator, something really struck me and I would appreciate your opinion on my comment. It seems that in the event of a black swan at the wrong time in ones saving history (and my event example of a black swan is the 5th percentile of a monte carlo or the historical worst of all the years PRC looks at), there is really little that can be done to alter ones financial outcome. What I mean is that saving more, saving longer, better return, lower inflation etc etc all have very little effect on the outcome, in the event of these poor outcome events, at least according to PRC.

    What do you think?
    Mike

    • Thanks Mike. I think you’ve pointed out an uncomfortable but important truth. Just because black swan events are inevitable and we can’t do much about them, doesn’t mean they can’t hurt. They can, especially if we aren’t diversified. A lot of the newer research I’m seeing points to your retirement date as a particularly critical juncture. If your assets take a bad hit around that time, it’s very possible they’ll never recover. There are new recommendations for an “hourglass” type of asset allocation — where you take on more risk (hold more stocks) in early savings years, and later in retirement, but minimize risk around the retirement date. I may have anticipated that, with a 50/50 stock/bond allocation in the years leading up to my own retirement. I was also fortunate to retire early in a bull market — though I had to endure the Great Recession to get there. Fact is, there is some apparent luck involved in the timing of your life events vs. market returns. But I do think you can improve your odds significantly by staying diversified — not piling into a single asset class based on what you think will happen in the future.

  3. Ingrid Polkinghorne says:

    Thanks again Darrow for bringing your followers important retirement info.

  4. Good comments. I might add it makes sense to keep your living expenses in retirement flexible and low. If something bad happens and you can cut your expenses you have a good chance of riding it out and recovering. My retirement income is projected to be about double my actually expenses which could be cut if needed. Just like in engineering it pays to over design your retirement. Which is what most retirement calculators are doing. I think spending is a more important variable than even income.If you can keep your basic expenses about your Social Security income I think you can weather down markets and snap back when they recover.

  5. Rather than “Black Swan”, I think the next mostly likely severe impact to the economic system, will be a US debt bubble collapse. It has 2 of the 3 attributes Taleb mentions, and differs only slightly on the first “outside the realm of regular expectations”. Detroit was on an “unsustainable path” for 20 years, only to blow up recently. One could be forgiven for forming “regular expectations” over the period of a generation. Similarly the expansion of US debt has a limit, the timing of which is unknowable and the consequences unimaginable. However, your suggestions on investment “best practice” and low fixed expenses stand in any environment.

    • Certainly high debt levels are on the short list of possible swans ahead. When and exactly how that gets resolved, I can’t guess. But there are some steps to stay out of the crosshairs. In addition to those investment best practices, how about Shakespeare: “Neither a borrower nor a lender be…” Thanks David!

  6. Tina in NJ says:

    Just found your blog via Money Magazine’s website. Finally, a financial blog for our life stage! I’ll be back. I got my hubby a tee shirt that said “Y2K Complacent” and he got a good laugh out of it (he works with mainframes). When the numbers rolled over, I woke the kid up at midnight and Hubby got lobster at work. Sigh. Anyway, I have so far found your blog well written and pertinent to my situation. Thank you.