Last week I mentioned how people tend to over-predict extreme events. It’s true. From shark attacks to lightning strikes to monetary collapse, people tend to be overly concerned about statistically remote events, and under-concerned about issues like highway safety or saving for retirement. It may be the news media or the nature of our minds, but we often obsess over statistically unlikely events to our financial and personal detriment.
But bad things do happen. Houses are not likely to catch fire, but if they do, the homeowner can be devastated, financially and personally. So because it’s a rare event that can have devastating personal results, buying insurance is rational. But the key is to have the right amount of insurance: too little, and you’re still exposed; but over-insuring means you’re spending too much on premium payments.
It’s the same way with investments. There are risks out there that if they happen to us, would be devastating. One example is monetary collapse. It’s happened before: post-revolution France, Weimar Germany, and post-war Hungary all experienced hyperinflation and monetary collapse. Bank runs, alternative currencies, barter transactions became common. Today, some people hold gold in their portfolios as insurance against such a possibility.
But hyperinflation is rare. It seems most common after a period of civil strife or war, when the country is getting back on its feet. If the chances of hyperinflation are 1%, then it’s rational to devote 1% of your assets to insurance. Any more than that and you’re over-insuring.
By matching our insurance holdings to the risks we face, we can avoid spending too much on premium payments. Having insurance is rational. But selling your home so you can afford the insurance payment is not.
Douglas R. Tengdin, CFA
Chief Investment Officer
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