In late 2008 the world financial system was on the verge of shutting down—and with one or two notable exceptions investors had nowhere to hide. Every asset dropped in price: stocks, bonds, commodities, real estate and precious metals—there wasn't any major investment class that escaped. Across the investment world correlations between securities all rose to "1" and diversification failed.
In the search for investment lessons from the financial crisis, the obvious suspect was the inability of traditional sources of diversification (stocks and bonds) to mitigate the damage caused by the market's collapse. As a result, considerable time and energy have been spent evaluating what kind of alternative investments would have been unaffected by the meltdown and incorporating them into new ETFs and other marketable securities.
If I've learned anything in my time in the investment world, it is that there is no perfect strategy, and no perfect outcome. "Don't put all your eggs in one basket" is an old adage because it is a brilliant insight and it has withstood the test of time. Diversification works, sometimes superbly, sometimes minimally. But it cannot work all of the time—nothing works all of the time. At some point a set of circumstances will arise that will foil even the most sophisticated, most comprehensive and most intelligently conceived strategy. The investment lesson from the financial crisis cannot be the failure of something that will never work 100% of the time.
No matter how successful, consistent or persistent the returns, every strategy is imperfect in some way. Therefore it is critical that investors understand what they risk when their chosen strategy fails. Will the damage be merely inconvenient or will it be catastrophic? Not understanding the vulnerability of a successful strategy is a recipe for disaster, as the following familiar story illustrates.
Hurricane Katrina made landfall early on the morning of Aug. 29, 2005. An hour or two later it slammed into New Orleans. Citizens and city officials had received ample warning and were well prepared for the potential damage. Storms in the Gulf of Mexico are a common occurrence, and local, state and federal agencies had a long history of coordinating their individual and collective responses.
Yet when the levees were breached that afternoon and New Orleans began to flood, a totally unexpected set of challenges arose. Despite years of experience with previous storms and floods, FEMA's operational structure was incapable of adjusting its response to the unique set of conditions it now faced. With regular channels of information compromised, what normally would have been a smooth integration of effort with local government agencies turned into a Kafkaesque power struggle over who had ultimate authority. Government officials could not see the flaws in their own thinking, and months later were still blaming the breakdown on the unusual circumstances of the storm.
In The Checklist Manifesto, Atul Gawande explains that the complex and rapidly changing needs brought on by the combination of the huge storm and the flooding overwhelmed the centrally based command-and-control structure on which government agencies relied. What the Katrina disaster demanded was for the decision making to be moved to the edges. There wasn't the time, communication or logistics available to fit the requirements of a centrally directed command structure.
Wal-Mart quickly realized that reality and instructed store managers to do anything they felt was needed to help their community—and the company would back their decision. As a result Wal-Mart was able to provide emergency supplies and drugs days ahead of FEMA.
