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Three Lessons from the Titanic

Thursday, April 14, 2016

The sinking of the Titanic on 14 April 1912 offers an opportunity to reflect on financial markets and the surveillance of the risk tolerance needed.

Today marks the anniversary of the sinking of the Titanic, which sank on the night of 14 April 1912. It was a tragedy that shook the broad public at the time and continues to exert a tragic attraction even today. However, the dynamics that led to the disastrous shipwreck offer at least three valuable insights and admonitions relating to the asset management industry.

What caused the Titanic to crash into an iceberg?

April 1912 saw particularly mild climate conditions in the North Atlantic, which favoured the formation of a number of icebergs that were above seasonal average; this increased the chances of them not being spotted – and therefore also the chances of a potential collision – but the disaster was mainly caused by human error.

The second officer, who was forced to abandon the trip on short notice, forgot to leave behind the key to the locker where the binoculars were kept. The key to a locker: a very trivial oversight that ended up having ruinous consequences.

Finally, the rivalry between the two transatlantic carriers to win the Blue Riband, the record of the fastest Atlantic crossing, played its part too. Captain Smith decided to proceed at full speed to get to New York aiming to break the record set by his competitor Cunard Line.

The time factor – timing in financial jargon – turned three unconnected factors into a fatal sequence: the high temperatures increased the chances of collision with the iceberg, which could have been spotted earlier had the binoculars not been locked away somewhere, while a lower speed would have allowed adequate room for manoeuvring and thus avoiding a collision.

Even the perception that something terrible was happening was deceiving. Passengers hardly noticed the impact with the iceberg: it was documented that some of them even used pieces of the iceberg in their drinks.

During the ship's construction phase at the Harland and Wolff shipyard in Belfast, the shipping company decided that a system of overlapping lifeboats would have compromised the ship's elegance. The provisions were reduced to 16 lifeboats, inadequate for the 2,000 or so people on board. But then what use are lifeboats on an unsinkable ship?

Lessons for manoeuvring financial markets today?

Three useful lessons can be drawn from the tragic story of the Titanic to better understand what is happening in financial markets today.

First, national governments seem unsuitable to match the challenges that come with a global economy which is getting more and more interlinked. The European Union is a good example for such disfuncionality with monetary measures in place albeit the absence of sound fiscal policies. Such disfuncionality between monetary and fiscal policy in the EU increases the current imbalances, thus turning it into a risk factor that requires careful consideration in the context of investment decisions.

James Carville, one of Clinton's advisers, said that if reincarnation exists, he wants to be reborn as the bond market, because "you can intimidate everybody". In fact, it is precisely the bond market that currently weighs on investors and policy makers worldwide. The collision with the iceberg of rising rates in the United States could trigger a reaction even greater than that experienced during the second half of 2013.

Rates kept low for such a long time make the sustainability of the life insurance policies sector in Europe one of the most serious challenges ever. However, the risks are mainly in emerging economies where between 2007 and 2014 debt grew on average more than the gross domestic product (GDP) and where rising Treasury yields and a strong dollar could trigger negative reactions. Therefore, it is necessary to be cautious with bond markets because risk is highly concentrated there at the moment.

A second lesson, valid for both professionals and money savers, concerns hubris. The 269-metre ship leaving the port in April 1912 seemed to defy the gods with its own invincibility. Only four days later, the unsinkable ship and its unfortunate passengers would see their destiny fulfilled.

Far too often hubris, or overconfidence in one's own abilities, has caused companies to fail and created financial crises. In 2000 there was talk of the end of the business cycle: technological innovation seemed to assure consistent productivity gains – the advent of a new paradigm. That collective enthusiasm proved short-lived and illusory; the bursting of the bubble in 2001 was as inevitable as the impact with the iceberg.

Just a few years ago the complex engineering of new financial products intoxicated markets. This overconfidence met its own iceberg on 15 September 2008.

Excessive reliance on one's own intelligence and ability is defined by cognitive psychologists as overconfidence; it is the risk that investors, professional managers and financial consultants run. Overconfidence is not always negative, but demands extreme vigilance: Apple and Microsoft were born out of confidence in their own abilities, but the same applies to Long Term Capital Management, Enron and dozens of other fatal episodes. Experience comes into play here: young traders, managers and consultants must sharpen their awareness in interpreting signs, learn from their mistakes and temper the virtues of caution.

The third lesson that we can draw from the sad story of the Titanic is knowing how to recognise change: the signs that are set to announce something new. The passengers didn't know that the impact would have fatal consequences – only those who were on the bridge saw the collision, and even they didn't grasp the situation's full magnitude. Survivors spoke of a "dull and muffled hiss” or “a finger brushing against the hull”.

We too, like the Titanic lookouts, don't have binoculars to help us recognise the arrival of the iceberg. When we realise that an iceberg exists and is on collision course, in most cases it will be too late.

However, we can avoid Captain Smith's mistake of trying to beat the crossing record by maintaining high speeds even at night. Forget the race with indexes, let's reduce our speed: in portfolios that means lowering risk, favouring less directional investment strategies, neutral and multi-asset markets that are widely diversified, with low volatility.

Binoculars for looking into the future don't exist, but if we train ourselves, over time we can avoid making costly mistakes and most importantly keep the ship afloat.

Nothing in this material constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. The statements and opinions in this material are those of the author at the time of publication and may not reflect his/her views thereafter. The companies listed were selected by the author to assist the reader in better understanding the themes presented. The companies included are not necessarily held by any portfolio or represent any recommendations by the author.
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