By Rick Waechter, Founder

Some of the greatest fortunes have been created by correctly forecasting where risk will rear its ugly head. Michael Lewis, in The Big Short, made famous the story of a few investors who saw the mortgage crisis coming in 2007-2008, bet against mortgage bonds, and pocketed tens or hundreds of millions of dollars. These kinds of stories, while wonderfully entertaining, mislead you. History is written by the victors. Most people who forecast risk get it wrong – and of course those stories typically don’t become best-selling books or popular films.

I have plenty of experience misjudging where risk will appear. Over decades, I have learned that the biggest risks come out of nowhere. My solution: don’t waste time predicting. Spend your time (and money) diversifying. That way, wherever risk comes from, you won’t be too exposed.

Here’s a story from my previous career in which a lot of smart, hardworking people spent hundreds of hours analyzing and protecting against various risks … and got it totally wrong.

I spent 20+ years as a Wall Street investment banker (cue the well-earned derision). One of the projects I remember most involved raising almost $2 billion for the government-owned telephone company in Indonesia, by listing their shares on the New York Stock Exchange and selling them to investors around the word.

The drill:

• To determine the appropriate share price, dozens of bankers made detailed calculations of future growth in revenue and expenses.
• We spent inordinate time understanding risks such as inflation, recession, regulatory changes, competition, new technology and the challenges of moving from a government-owned company to a market-facing company.
• We then created a detailed financial model to incorporate every key variable, and to run all kinds of sensitivity analyses.

Much of the analysis was solid – or would have been solid. Except for one, ahem, small thing we missed. The Indonesian currency, which had steadily and predictably depreciated gradually against the US dollar for decades, collapsed about two years after the shares were listed. The currency fell by 75%+ in a year. The shares became almost worthless to US dollar-based investors.

We had considered all kinds of risks, and – working with the Indonesian government – we had agreed to protections like a strong regulatory regime.

But we flat-out missed the risk which mattered most.

Many investors today are worried that a bursting “AI bubble” may cause high-flying U.S. tech stocks to drop, potentially sharply. It may. But if you want to protect yourself against that risk, don’t do it by taking on another big risk – buying gold, or Bitcoin, or junk bonds, or art, or your next-door neighbor’s can’t-lose deal. The only reliable way to protect yourself as an investor is by diversifying across geographies, sectors, and company sizes within stocks, high-quality bonds, and potentially real estate or reputable private investments.

None of knows where the next risk will come from. Take it from me. I’ve made that mistake one too many times.

(PS – the Indonesian telephone company’s stock rebounded strongly after a few years, if any investor had the nerve to hold on. I suspect few did.)