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 (AIG +0.85%) 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.
