You'll Never See The Next Crisis Coming

The desire to forecast and predict future events is human nature. Whether a gambler, investor, or sports fan, humans tirelessly attempt to emulate Shakepeare's Soothsayer from "Julius Caesar" and accurately foretell the unexpected.

Prideful predictions
Every March, we pour over historical data and past schedules in hopes of picking the eventual champion of the NCAA Men's basketball tournament so we may have the chance to gloat and stick out our chests. Inherently, investing involves attempting to pinpoint opportunities but, more importantly, avoid blatant risks. Investors often take more pride in identifying the next crisis rather than discovering the subsequent boom business or industry.

As a result of the continuous flow of financial news and data available to investors today, many market participants, particularly retail investors, spend more time forecasting the next crisis rather than accepting the notion that the catalysts of crises and catastrophic losses can be nearly impossible to foresee. While some may consider using the word "impossible" too extreme, AIG's (NYSE: AIG  ) drastic downward spiral during the 2008 financial crisis serves as an appropriate example.

How could we be so clueless?
Sitting here in 2013, every investor associates AIG's downfall with its incredible exposure to credit default swaps (CDS). We wonder how investors were so blind to the danger and risk of investing in a company that would ultimately bring the financial world to its knees. While those managing the insurance behemoth at the time may have understood the potential risks of their internal operations, investors' only glimpse into the company was through the window of SEC filings and annual reports. These public documents are intended to communicate the explicit risks associated with the business.

In 2007, AIG's CDS portfolio began to turn sour when it posted an unrealized loss of more than $11 billion on contracts written for super senior tranches of multisector collateralized debt obligations. Despite the market deterioration, in AIG's 2007 annual report, the company reassured investors:

"Based upon its most current analysis, AIG believes any losses that are realized over time on the super senior credit default swap portfolio of AIGFP will not be material to AIG's consolidated results of operations for an individual reporting period."

Ultimately, the company posted another $28.6 billion loss for that portfolio in 2008 and a net loss of $99.2 billion for the year. How could investors not have anticipated this? The answer is simple; AIG did not provide any detail in its 2005 and 2006 annual reports about the risk associated with its CDS portfolio. The number of times the company even mentioned credit default swaps in those two reports is five.

Source: AIG annual reports.

Long-term investors have to realize that predicting the next crisis is a futile effort. Devastating losses and shocking events will undoubtedly happen. Those interested in sleeping at night and building a strong, long-term portfolio should wisely spend their time on identifying valuable companies and accepting the fact that identifying the next disaster is about as hard as filling out a perfect March Madness bracket.

At the end of last year, AIG was the favorite stock among hedge fund managers. Have they identified the next big multi-bagger, or are the risks facing the insurance giant still too great? In The Motley Fool's premium report on AIG, Financials Bureau Chief Matt Koppenheffer breaks down the key issues that you need to know about if you want to successfully invest in this stock. Simply click here now to claim your copy, and you'll also receive a full year of key updates and expert analysis as news continues to develop.

Read/Post Comments (5) | Recommend This Article (6)

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  • Report this Comment On March 20, 2013, at 9:23 AM, TMFMorgan wrote:

    That chart is great. Good article!

  • Report this Comment On March 20, 2013, at 9:52 AM, rkiefl wrote:

    There's no doubt that you're correct that the future in unpredictable. The fact that we've had a number of recessions over the past 80 years that show up about every 7-10 years does suggest a pattern, and a constructive one at that.

    And though I agree with your principle for investing in companies over the long term, I would feel foolish if I didn't risk manage my portfolio for future opportunities. And with that, as we've now entered the greedy phase of the market cycle, one would be wise to begin the process of slowly taking some gains from their portfolio in preparation for what is not necessarily definite but likely to come. My personal target is to reduce my portfolio to 66% invested this year, and wind it down every 6 months from there.

    Do I see it coming? Hell no, but that doesn't mean its out there. At some point over the next 2-5 years I think we're likely to see a dip and in my mind this is wise risk management. And this approach will also allow me reap some future gain from what will likely continue to be a growing market.

    So I guess I have a different fundamental perspective, while you choose to invest in solid companies, I choose to invest in macro economies first and solid companies second.

    Though we can't predict the outcome of a championship match, with greater accuracy we can predict the likely teams who will play in that championship match.

    Within the US economy we have plenty of candidates to choose from. There are a number bubbles including education debts, health care debts just to name a few, and there is an impending change in monetary policy (unless the US wants to go the way of Greece). I'm also concerned with the options markets and the eerily similarities it shows towards mortgage derivatives but I do believe that to be longer term. It could be any or none of these things, but it will eventually happen. We just don't know when until its too late.

  • Report this Comment On March 20, 2013, at 10:26 AM, TMFBomb wrote:

    Nice, simple, telling chart, David.

  • Report this Comment On March 20, 2013, at 11:41 AM, Seanickson wrote:

    you cant predict all crises but you can predict some. the tech and housing bubbles were there for anyone to see and many did see them. Keeping your eyes open is crucial to perhaps avoiding a major crisis or even better, profiting from it.

  • Report this Comment On March 21, 2013, at 8:16 AM, The1MAGE wrote:

    I thought the tech bubble was obvious, and I did see the real estate bubble, though I didn't expect it to hit the banks like it did. But there was never a way to predict exactly when the bubble would burst.

    Both of these events had the same obvious signs, that people were acting stupid.

    Interestingly I also won an informal bet about the price of crude. A person tried to convince me it would never go below $100 again, and during the 2008 crash id dropped below that. But he never did eat his underwear.

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