Investing for the Worst-Case Scenario

Losing money stinks. There's nothing worse than taking a loss that could've been prevented. So let's consider two simple ways that I think can help investors avoid permanent capital impairment.

Ask the tough questions that no one else will
Before the housing debacle and credit crunch, ignoring things like liquidity and credit risk was easy. If you wanted a loan, banks would beg you to take one. The question about housing prices wasn't whether prices would go up, but by how much.

Don't get me wrong -- it ain't easy being different and asking tough questions. Imagine you're at a raging party, and everyone's having a great time and the music's blaring. Do you want to be the guy who cuts the music, takes away the punch bowl, and kicks everyone out before the party gets out of hand? Good luck getting invited to the next shindig.

Nevertheless, prudent investors should not only make sure they're asking the tough questions but see that their management teams do the same. In July, former Citigroup (NYSE: C  ) Chairman Chuck Prince said, "As long as the music is playing, you've got to get up and dance. We're still dancing." A couple of months later, Citigroup announced that it expected to take a loss of $8 billion to $11 billion on subprime and CDO holdings, and Prince resigned.

Now, contrast that statement with one from Berkshire Hathaway's (NYSE: BRK-A  ) chairman Warren Buffett, who stated in his 2004 shareholder letter, "A $100 billion event or even a larger catastrophe remains a possibility if either a severe earthquake or hurricane hits just the wrong place."

About five months later, Hurricane Katrina, the most destructive hurricane in insurance history, hit Louisiana. Although Katrina stuck Berkshire with a $2.5 billion tab, Berkshire still made a slight $53 million underwriting profit in 2005 -- this in a year widely regarded as the worst in catastrophe-insurance history.

As an investor, you're better off going with the management team that asks the tough questions and is thus prepared when the storm hits. 

Stress-test the outliers
As investors and human beings, we spend way too much time trying to figure out the most likely scenario and too little time thinking about the outliers. According to the California Earthquake Authority, only 12% of Californians bought earthquake insurance in 2007, down from 30% in 1996. Clearly, these people aren't appreciating the extent to which an infrequent but ultimately inevitable risk will devastate their most important assets.

It's really easy to ignore outliers, sometimes to devastating consequences. Investment bankers at Merrill Lynch (NYSE: MER  ) and Bear Stearns (NYSE: BSC  ) , and even those whose very jobs it is to think about these risks, like the analysts at Stock Advisor recommendation Moody's (NYSE: MCO  ) , are now in a huge pickle -- precisely because they didn't adequately stress-test their models to account for the possibility that housing prices could fall sharply.

Clearly, investors need to spend a lot of time thinking about worst-case scenarios. What happens if sales plummet? What happens if a recession hits, interest rates soar, oil prices spike, or housing prices continue to slide? These things can and do happen, so investors should be prepared.

Foolish thoughts
In my investing history, I've made tons of mistakes because I either didn't ask the tough questions, didn't accurately calculate the outcome of a worst-case scenario, or invested with a management team that had similar shortcomings.

It's tough to find stocks trading at valuations lower than what they'd be worth in a worst-case scenario. It's tougher still to find such companies that are also run by capable and qualified management teams, especially since the presence of capable management usually precludes such a scenario. But investors who wait for these types of situations will often earn rich rewards.

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