The top three extreme risks for investors to watch are global temperature change, global trade collapse and cyber warfare, according to a new report by Willis Towers Watson’s Thinking Ahead Institute.
In the report, extreme risks are considered events that are highly unlikely to occur — but could have a large impact on economic growth and assets should they occur.
“Our extreme risks ranking has seen the emergence of a general trend, with financial risks falling down the rankings and non-financial extreme risks growing in significance,” said Tim Hodgson, head of the Thinking Ahead Group, in a press release. “Global temperature change becomes the highest ranked risk due to our assessment of higher likelihood coupled with significant impact — in the extreme this would mean mass extinction.”
Other risks getting higher billing were infrastructure failure, up eight places to seventh place and a currency crisis, up three spots to fifth place.
“We believe that the world is subject to fundamental changes, whether environmental or political, which will alter power balances,” said Hodgson. “A complex world can and will deliver extreme outcomes that are hard to imagine when working with a normal distribution. That means extreme events are much more likely than previously thought. To navigate through this complex world, 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.”
In seeking to hedge against these and the report’s other risks, institutional investors can take on three strategies, according to the report. First, they can hold cash, which tends to hold its real value through both episodes of deflation and inflation. However, there is no guarantee this will continue to be the case in future, the report noted.
Further, institutions can make use of derivatives. These comes with their own set of risks, however. “The cost of derivatives protection can often be reduced by specifying more precise conditions — but the more precise the conditions, the greater the chance that they are not exactly met and hence the “insurance” does not pay out,” the release noted.
Finally, institutions can ensure they’re holding negatively correlated assets, it said. But no single asset can work against all possible negative outcomes and there is no guarantee any specific asset will perform the hedging effect it’s held to achieve.
“I see extreme risks thinking as an exercise for the mind,” said Liang Yin, senior investment consultant at the Thinking Ahead Group. “They remind us that it is naive and dangerous to cling to a single vision about the future. Yes, we do not know what the future holds. But our brains are more than capable of imagining multiple versions of the future. As investors we are trying to navigate a highly volatile, uncertain, complex and ambiguous world. The scenarios are most effective when they are used in a deliberately created, interactive environment to make explicit assumptions — and to challenge assumptions — that underpin your investment portfolios or your business strategy.”