They’re called “black swan events” — things so unlikely they almost never occur.
A nationwide home-price decline is a black swan event. So is a nearly unstoppable deepwater oil spill, or a government bond default, or a recession worse than anything since the Great Depression.
The problem is a black swan event can be devastating, so there needs to be some preparation even if the odds are very low that it will occur. But preparing has costs, often huge ones. So how do you strike a balance?
We could avoid deepwater oil spills by banning deepwater drilling, but we need the oil. You could avoid a devastating stock market collapse by keeping your money in cash or gold, but then you might not get enough investment growth to fund your retirement.
The first step in balancing risk and reward is to avoid situations that really aren’t black swans. A nationwide housing-price collapse is very, very rare, but a local one is not, and for the homeowner there’s really no difference. So it may be too risky to buy in a market where prices are rising much faster than incomes.
Risk is also reduced by minimizing “concentrated” investments, which means putting a lot of eggs in one basket. If home prices drop, an expensive house will hurt you more than a cheaper one.
Diversification is also the best way to reduce risk in investments like stocks, bonds and mutual funds. If you had all your money in BP stock (Stock Quote: BP), you’d have seen your shares fall about 50% because of the Gulf oil spill.
Had you invested in a mutual fund tracking the Standard & Poor’s 500, you’d be down just 10%. You’d have lost even less if you’d kept a chunk of your holdings in bonds or bond funds.
Of course, it also makes sense to have a cushion, so you can wait out a black swan event in hopes of enjoying a rebound. With the cheaper home, you can hang on longer, even if the same event that undermines your property’s value torpedoes your income. A good rainy-day fund will help.