Extreme risks—events that are unlikely to occur—should be considered by institutional investors because they could have a significant impact on returns, according to a report.
The Towers Watson report, Extreme Risks 2013, says the top 15 risks now for the first time include stagnation, health progress backfire, nuclear contamination, extreme longevity and terrorism.
Those that have dropped out of the top 15 this year are eurozone breakup, hyperinflation, political crisis, major war, end of fiat money and killer pandemic.
It says considering extreme risks can be useful in helping to design more robust investment portfolios and more robust risk management processes.
To deal with these risks, diversity is key. By diversity, the report means having exposure to as broad a number of different risk premia/return drivers as possible, such as holding cash, buying derivatives and holding a negatively correlated asset.
“To navigate through this complex world,” concludes the report, “we suggest investors need to be open-minded, avoid concentrated risks, be sensitive to early warning signs, constantly adapt and always prepare for the worst.”