Planning for Diaster - The Black Swan Risk
In September of 2017, we had a close call with Hurricane Irma in Florida. I thought the experience was valuable (after it was over of course) in teaching my kids about unexpected risk and how it can apply to investing. The investing lesson comes at the end, but first the setup and about planning for previous risk events and how they can go awry when the Black Swan shows up.
We've lived in S. Florida since 1993 and have experienced a number of hurricanes. We had planned for them successfully until Irma.
In the past, most hurricanes have moved across Florida from East to West or occasionally from West to East. We usually have a couple days' warning to let us know whether to head South to a hotel in Miami or North to a hotel in Orlando. Once we went to NY for fun. We have our bags packed, the car filled with gas and reservations at both hotels in Miami and Orlando. We try to leave a day before everyone else does to avoid the rush. We've done this more than a few times over the 25 years we've been in Palm Beach County so I was confident in our plan.
We have 3 large airports within an hours drive from us and always thought that if there was a large storm, we could get a flight to somewhere in the North East. We have a small dog so we can't fly more than 3 or 4 hours due to his need for a bathroom break. Worst case, I thought we could charter a plane out of the local airport, which is 10 minutes from our house. It's expensive, but we'd only need the charter one-way to get out.
Here's the timeline, it shows how well thought out plans can fall apart quickly in a black swan event. On Sunday, Sept 3, 2017, the news/weather report showed that Irma was a major hurricane and could potentially hit Florida but if it hit, it wouldn't be until the following Sunday. That gave us 3 days to see if Irma was going to change course and if not, still be out of our house by Thursday, 3 days before it hit. As those of you in S. Florida know, the hurricane forecasts a week out aren't very accurate. They usually don't know where the hurricane is going to hit until 48-72 hours prior to landfall.
By Tuesday evening, it was clearer that Irma was a monster hurricane and was highly likely to travel up Florida from the South to the North. Irma was extremely large so it was very possible that both coasts of Florida would have hurricane force winds. One coast could get hit with Category 5 winds while the other Category 1 winds. The forecast couldn't determine which coast would get hit by the Category5 winds so people from all over Florida started to evacuate.
When you hear the expression, “everyone is running for the exits”, picture this. Florida has about 20 million residents. About 1/3 of them were told to evacuate their homes. There are 2 major roads that lead out of South Florida. Orlando is normally a 3 hour drive from our house. Friends, who drove to Orlando on Wednesday, spent up to 12 hours in traffic. Atlanta is normally a 9 hour drive from us. We had friends who spent 24 hours driving there, taking breaks by sleeping on the side of the road.
We also had friends who drove 12 hours to Tampa only to be told the next day that their hotel was being evacuated because Irma had changed paths. They had to drive another 15+ hours to New Orleans.
We didn't want to get stuck in traffic so we thought we would just fly somewhere. But by Tuesday evening, we weren't the only ones with that thought. We couldn't get a commercial flight anywhere on the East Coast. There were a few flights to San Diego or HI but that wasn't an option with our dog. We talked with a friend who was also stuck with her daughter. We decided to charter a plane and head to NY. The charter was set for Wednesday morning. We got a call in the morning telling us that the charter was canceled. We found another charter company and re-booked for Thursday morning. On Wednesday night, we got a call that that one was canceled as well. I called every charter company I could find and there weren't any planes available.
We were stuck in Florida and hoped that Irma wouldn't come up our doorstep. We live in a well-built, concrete house with a newer roof, hurricane shutters and a generator. All that is comforting in a Category1 or Category2 storm. It's not so comforting if a Category5 is coming your way. Just by chance, the storm shifted further east and hit the West coast of Florida as a Category5. Luckily, we only got hit by Category1 winds.
Here are the lessons we all learned from this.
1 - When there's a Black Swan event, everyone is going to be running for the same exits you had planned to use. Some investors ride a stock or index because of momentum. They think they can get out when it starts to pull back, and most of the time they can. But when everyone is heading to the exits at the same time, it's not so easy to get out. During most of 2017, the market was going straight up. As of January, 2018, our allocation was over 95% equities and our models were indicating it was time to reduce our exposure. It is not an easy decision to sell when your portfolio is increasing at over 1/3 of a percent a day. Most people thought it couldn't last forever, but it was certainly possible to ride up another 10%-15%. Our experience with Irma had a significant influence in the decision to reduce our equity exposure.
2 - Preparation is great, but it's difficult to prepare for something that hasn't happened in recent history. We all remember the financial crisis of 2009, most of us remember the dot com crash but not many of us were around for the Great Depression. One of the best strategies we've learned is that being prepared for an expected downturn is a better strategy for us than trying to maximize returns. In the example above, when we cut our equity exposure from 95+% to the low 80s, our outlook changed. Instead of worrying that the market might tank 20%, we were hoping for it. We had our buy prices set (limit orders) in case the stocks we sold pulled back. Setting yourself up in this way is one of the most important strategies you can learn. If the market goes up 20%, you're still 80%+ long and you win. If the market drops 20%, you can use the cash from the positions you sold to take advantage of the drop. In order to receive the most benefits from this strategy; you have to have some metrics to measure the market. If the market is significantly undervalued, and you're a long term investor, 95% long might be ideal.
3 - It's better to get out early and be wrong (the stock or index continues up) than to try to hang around a little longer and potentially get killed. This was a lesson that we've used in our investing for many years but hadn't translated into our hurricane plan. We have metrics that we adhere to in our portfolio management: there are minimum dividend yields, maximum leverage rules, etc. We've sold stock in many companies where we still liked the business model, but the metrics no longer fit our criteria. For example, we bought SPGI in the 40's, sold it in the 90's and watched it double again in the next 2 years. Far from the only stock we've sold early. In a strong economy and a strong market, leverage can and often does amplify gains. Investors are rewarded for taking additional risks. The problem occurs when the storm comes.
During the previous hurricanes, we didn't get out early and were never punished for it. Fortunately, we learned our lesson with minimal damage.
