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| Worthy Notions: From the Editor |
Fear Itself
Dwight Cass
10/01/2004
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From the Worth editorial offices in Manhattan you can see a half-dozen or so
news vans, bristling with satellite antennae, lined up near the Citigroup
building on Lexington Avenue. The midsummer alerts about potential terrorist
attacks against financial institutions in and around New York and Washington,
combined with the extraordinary security precautions necessary to ensure public
safety during the Democratic and Republican conventions, have refocused
attention on this threat, and unnerved many individual investors.
 In the
course of assembling our 100 Most Exclusive Financial Advisors list this year,
we learned that the risk of terrorist attacks, and their impact on investments
and business conditions, is a leading concern for many of our readers, and one
that financial advisors are struggling to address. These professionals are hard
pressed to help their clients understand the nature of this hazard, and how they
can hedge against it.
The best minds in the financial sector have puzzled
over how to fit their calipers around this amorphous issue, and met with only
limited success. The industry has not developed an insurance policy or a
financial instrument that provides broad protection from loss due to a terrorist
attack, mainly because it cannot ascertain the probability of such an event. It
cannot, therefore, put a price on the risk that would allow one party to pay
another for bearing it. The one attempt to harvest market insights about the
probability of terrorist attacks, the Pentagon’s Policy Analysis Market—a system
for speculators to buy or sell futures contracts based on their view of the
probabilities of attacks, assassinations and similar events—was aborted in the
face of widespread criticism in mid-2003.
Because of this difficulty, banks
use a somewhat more prosaic tool—the stress test—to ascertain their
vulnerability. They run computer simulations to see how their assets would
perform under various historical scenarios—the 1987 market crash, the 1994
interest rate rise, the 1997 and 1998 Asian and Russian financial crises, the
2000 dot-com meltdown and the 9/11 attacks, for example. These tests allow the
banks to ascertain how much market stress they can endure, and to use these
limits to guide decision making.
The risk to our investment legacies from a
terrorist attack may be smaller than we anticipate. Indeed, given the immense
scope of the human tragedy, it is hard to believe how little effect 9/11
actually had on the performance of the financial sector and the markets in
general. This was due to many factors. Many institutions had full-scale backup
facilities available; normally sangfroid and eagle-eyed arbitrageurs let market
opportunities pass by rather than exploiting the crisis; the New York Fed poured
an unprecedented amount of liquidity into the market; and many firms supported
their stricken rivals, even giving them access to trading floors.
The
emotions that terrorism stirs compound our uncertainty and may lead us to make
impulsive and unwise investment decisions. If we want a better understanding of
our own portfolio’s vulnerability, we can take a page from the experts’ book and
work with our advisors to devise appropriate stress tests. We can determine how
much we would lose, and from which assets, under a variety of crisis scenarios,
including a terrorist attack, using the market reaction to 9/11 as a
template.
If we find that some of our assets are at significant risk, we can
deliberate carefully with our advisors over how best to reduce that exposure.
The most astute financial advisors on our list already perform this and similar
analyses for their clients, some of whom have found that they are far less
vulnerable than they feared.
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