Towers Watson acknowledges that investors can't plan for every potential risk to their portfolios, but in a new report it recommends that investors take into consideration not just financial or economic risks but political, social, environmental and technological risks as well.
The author of the report – Extreme Risks 2013 – encourages investors to be open-minded, avoid concentrated risks, be sensitive to early warning signs, constantly adapt and always prepare for the worst.
The top "extreme risks" for 2013 are food, water and energy shortfalls; stagnation, which is a period of little or no economic growth; global temperature change; depression, or a deep trough in economic output with massive increase in unemployment; global trade collapse; a banking crisis that stems from a lack of liquidity; sovereign default where a major sovereign borrower defaults on its loans; a currency crisis where there is extreme movement between exchange rates; deflation; a major health pandemic; nuclear contamination, extreme long life, insolvency within the insurance sector, terrorism and an interruption of a major infrastructure network.
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The way to manage some of these risks is to build a robust and diverse investment portfolio, Towers Watson said. That means exposing your portfolio to a broad number of different risk/return drivers to reduce the risk that forecasts about the future are wrong.
The next step is to explore hedging strategies such as cash, which is the easiest and most underrated source of tail risk protection, according to the report. Cash has held its real value through deflation and inflation, but there is no guarantee that this will be the case in the future, Towers Watson said.
Derivatives are another hedging strategy. Pension funds that worry about extreme longevity can purchase a longevity swap or a Credit Default Swap to insure against non-payment by a sovereign borrower, the consulting firm said.
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