Investment Lessons From the Space Shuttle Launch: Responding to Disaster

Watching Tuesday's launch of the space shuttle live on CNN got me thinking about risk management, since alot of the commentary was about the threat of foam falling off the shuttle’s exterior, just as had been in the case during the Columbia disaster when the shuttle was destroyed upon re-entry from space.

They also discussed other possible mishaps. The comment was made that at one point all the astronauts as well as technicians down on the ground were thinking the same thing: “Hope I didn’t forget something” or “Hope I don’t mess it up.” Though only discussed for a relatively short period of time, it was a rather uncomfortable tone for what was a very nice July 4 day in Cape Canaveral.

So, the question I have is what risk management process did NASA go through after Columbia? NASA is the home of the real “rocket scientist”. I recall from the movie Armageddon, one of the NASA guys trying to figure out how to save the world from a giant meteor’s impact was supposedly “the smartest guy in the world.” Really now? Well, if there’s a book on the subject, I’d be interested in reading it.

Should be good for investors to consider that “black swan event” (term from Nassim Taleb’s book Fooled By Randomness), how best to plan for it, and how to deal with it when it eventually happens.

Just a thought. Are there little things that can happen (consider something as insignificant as a piece of tile falling of the underbelly of the shuttle) that could cause so much trouble that it causes massive damage to an entire entity? That tile is clearly no longer considered insignificant. Of course there are many potential causes for the markets, and thus your portfolio, to have a serious disaster. There are numerous scenarios starting with countless initial events that could cause a cascading effect resulting in a major market meltdown.

Now, we really don’t have to consider a complete “total destruction situation” where a diversified portfolio falls to zero. However, we can all think of scenarios which lead to a 50% loss or more. I’m not sure that the actual number is important. I’m not even sure if the causes are important because, frankly, can we do anything about it? What is important is to remember that in times of complete distress in the markets, correlations spike close to 1. This means that the benefits of diversification fail investors when they’re needed the most. There’s a similarity where distress to a certain component of the shuttle may lead to its total destruction.

So what should be of high importance to investors is what can be done on relatively short notice to cushion the blow of a quick and major market downturn?

First, before trying to trade your way out of trouble, make sure the basics are in place: diversify your portfolio well with various uncorrelated and even negatively correlated positions. Strategic asset allocation is key including the importance at times for high safety positions (cash/gold). Diversification fails, but not often.

When it does fail, not everything fails completely. VIX options and futures are good examples of instruments which are very negatively correlated with general market trends, although truly effective as a short-term play. Broad market equity index derivatives (buying put options, shorting index futures) are a cheap and easy method. But with the recent inverse ETFs, there’s a choice for investors who are accustomed to holding only long positions in funds. These funds have been discussed numerous times before, but here’s the list again:

* Short QQQ ProShares (Amex: PSQ)
* Short S&P 500 ProShares (Amex: SH)
* Short Dow 30 ProShares (Amex: DOG)
* Short MidCap S&P 400 ProShares (Amex: MYY)

In all cases, when you start to consider these as potential positions, you have to switch from your “strategic asset allocation hat” to “tactical asset allocation”. It just doesn’t make sense holding these positions for very long unless you are in a serious decline like in 2000-2002 or those of the early and mid 70’s. On the other hand, all of these potential choices have a cost if you’re wrong about the direction of the market. Clearly that’s what hedging is all about.

You buy insurance for your home, car and body. Assuming you keep up your home, change your car’s oil and are disciplined about daily vitamins and exercise, doesn’t your diversified portfolio require insurance as well?

My argument is that it’s slightly different for a portfolio. I don’t think you need continued exposure to a hedged position (long put, inverse ETF position or otherwise) as you do with daily vitamins. But with TAA, it’s all about the timing. Yeah, it’s tough. But it’s not rocket science.