Lusitania
On May 7, 1915, a German U-boat fired a single torpedo at the Lusitania, an ocean liner carrying 1,959 passengers and crew. The ship sank in less than 20 minutes, killing 1,195 people. Among the dead were 27 infants.

The sinking of the Lusitania was a horrific tragedy that is the subject of Erik Larson's latest book, Dead Wake: The Last Crossing of the Lusitania. After reading this gripping story, I was struck by how much investors can learn from this event about managing potentially catastrophic risks.

Forewarned is forearmed
Even though the disaster seemed unthinkable at the time, Germany had actually warned passengers beforehand about a possible attack. And because the passengers and crew were in denial about the dangers they were facing, they were unable to respond effectively in the brief moments after the vessel was hit. One big lesson from the book is that it's essential to prepare ahead of time for possible disasters, regardless of how unlikely they may appear.

Just two weeks before the torpedo attack, Germany made it clear that all enemy and neutral vessels traveling the waters around Great Britain were at risk. In a newspaper blurb published in American newspapers in late April 1915, the German Embassy warned that, "vessels flying the flag of Great Britain, or of any of her allies, are liable to destruction" and that "travelers sailing in the war zone on ships of Great Britain or her allies do so at their own risk." Even though it carried 189 Americans (the United States was neutral in 1915), the Lusitania was a British ship that was traveling from New York City to Liverpool, England. According to Germany's declared policy, the ocean liner was fair game for an assault.

Whistling past the graveyard
Larson tells us that very few passengers took Germany's warning seriously. Most people couldn't believe Germany would do such a thing. And besides, an attack against a big, fast ship would surely fail. Larson quotes a ship stewardess who said:

Of course, we heard rumors in New York that they were going to torpedo us, but we didn't believe it for one moment. We just laughed it off, and said they would never get us, we were too quick, too speedy. It was just the same kind of trip as it was any other trip.

Captain William Thomas Turner, the ship's commander, was also very skeptical of any trouble. He told a reporter:

Do you think all these people would be booking passage on board the Lusitania if they thought she could be caught by a German submarine? Why it's the best joke I've heard in many days, this talk of torpedoing the Lusitania.

The passengers and their captain were clearly fooling themselves about the impossibility of a disaster at sea. This is very similar to what we hear from investors about potentially catastrophic financial events. When house prices were soaring ever upward in the years leading up to the financial crisis, we shrugged off the dangers of a bubble by telling ourselves, "this time it's different." And nowadays, folks who don't have enough saved for retirement convince themselves they'll just work into their 70s – a belief that assumes they won't have health problems or won't be laid off before then. Somehow, human beings seem wired to blissfully ignore huge risks they face in a wide variety of different areas.

Do you know where your life jacket is?
How could passengers have better managed the risk of a torpedo attack? The obvious thing to do might have been to cancel your voyage once you read the warning by the German Embassy. Alas, only two passengers canceled their trips upon hearing the announcement.

For those passengers deciding to go forward with their travel plans, it might have been smart for them to have a plan in case of a torpedo attack. Something as basic as knowing how to use one's life jacket could have been the difference between death and survival. Unfortunately, many of the Lusitania's passengers who died that day had never learned how to wear their life jackets properly.

According to Larson, first- and second-class passengers had been provided with the latest in life jackets. If the jackets were worn properly, "they were effective in keeping an oversized man afloat, comfortably on his back."

Sadly, very few of the passengers even knew how to put them on correctly. Larson writes:

Many who entered the sea had their jackets on incorrectly and found themselves struggling to keep their heads out of water. The struggle did not last long, and soon survivors who did manage to outfit themselves properly found themselves swimming among bodies upended in poses their owners would have found humiliating.

Larson notes that those who wore their life jackets incorrectly were often upside-down in the water. He calls them the most ill-starred of passengers.

Safety first for your portfolio
In the investing world, it's often the most basic advice that can help prevent a portfolio disaster. For example, it might make sense for you to have an emergency fund of cash that can sustain you for three to six months, in case you lose your job or markets go haywire. You may also want to make sure you are not carrying too much debt. In a wise list of lessons from the Great Depression, a successful investor wrote, "Never borrow money without continuously reviewing and questioning your ability to pay it back under the worst conditions." Another market fall of roughly 50 percentage points like the one from October 2007 to March 2009 might seem like a low-probability event, but having a contingency plan in any case could be essential for the survival of your portfolio.

The price of being unlucky
Among the passengers and crew on the Lusitania were Mrs. Arthur Luck and her two young sons, Kenneth Luck and Elbridge Luck. Obviously, the Luck family, along with the other 1,956 people on board, were extremely unlucky on that day in May 100 years ago. With even the most basic of safety preparations, however, many more of them would have survived the deadly torpedo attack.

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