The Yellowstone Factor: Minimizing Downside Risk
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Excerpt:
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Yellowstone National Park is volcanic in nature, yet not one cone or caldera is visible. In the 1960s, this mystery was finally solved: The entire park -- 2.2 million acres -- is the caldera. It's the largest active supervolcano on Earth. Yellowstone started erupting about 17 million years ago, and it has a cycle of erupting roughly every 600,000 years. The last eruption was 630,000 years ago, so it's about 30,000 years past due on the next big one.
By 1984, Yellowstone's restless magma chamber caused the entire central region of the park -- several dozen square miles -- to be lifted 3 feet higher than it was in 1924. The area subsided by 8 inches in 1985, but it appears to be rising again. Although volcanic eruptions are very hard to predict, telltale signs of a forthcoming eruption are already there. Earthquakes are a precursor to volcanic activity, and there were 1,260 of them in the park in 2002 alone.
When Yellowstone awakens from its slumber, it's unlikely any humans within 700 miles of the park would survive. An area the size of New York State would have ash 67 feet deep. The aftermath probably would be worse, with no sunlight for years throughout the planet and much farmland rendered useless under mountains of ash. Humans have no memory of living through such devastation. (Thanks to Bill Bryson's A Short History of Nearly Everything for the data.)
Outliers
Yellowstone represents just one of the many ugly outlying events that have an extremely low probability of occurring, but that does not mean the odds are zero or that they can be ignored. Even the most seemingly resilient businesses are very fragile temporary creations by their nature, and it would take a lot less than Yellowstone's eruption to wipe them out. The Yellowstone Factor alone implies that there isn't a single business on the planet whose future is assured.
Minimizing downside risk is the first step toward being a successful investor. As Warren Buffett succinctly puts it:
Rule No. 1: Never lose money.
Rule No. 2: Never forget Rule No. 1.
You always need to be cognizant of six sigma events that can have an ugly impact on your portfolio and account for the approximate probabilities. Whenever I look at any investment opportunity, I first fixate on what factors can cause the investment to result in a significant permanent loss of capital. Besides Yellowstone, there are the usual suspects: wars, terrorism, fraudulent financial statements, dishonest management, disruptive innovation, etc. But how can you figure out the probabilities for each one? -
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