I tend to think that we are on the verge of a global economic and societal collapse driven by diminishing marginal returns on civilization’s investment in complexity—especially by the declining availability of surplus energy. I don’t think that this will result in a single, catastrophic collapse event, but rather in a slow, grinding decline that is masked by epiphenomena and the confusion of symptoms and causes, effectively negating our ability, as a society, to muster the will to take effective mitigation measures. I also think that there is a reasonably high probability that I am dead wrong. I don’t have a crystal ball—all I can do is attempt to project trends into the future, and guess at the outcomes of our massively non-linear planetary-societal system. Humans tend to have a very poor track record at predicting the long-term future—why should I not be subject to the same limitations? After all, conventional wisdom says that things will keep on much as they always have, that we will find a way to overcome. Here’s the grand challenge: if individual or societal plans for the future focus only on collapse, or only on continuation of the status quo, then the high probability that the alternative occurs will be catastrophic. Further complicating matters, there are certainly more than two possible future scenarios. How does one hedge against the multi-dimensional future solution space?
I am beginning this discussion with the assumption that none of us know what the future holds. We can, however, identify possible future scenarios. Not all of them, of course. Rather, I am proposing a “future solution space” methodology that uses current trends or indicators as dimensions. Then, based on my belief that risk is mispriced (based largely on continued reliance on variations of the Gaussian-derived Sharpe Ratio for portfolio risk management and Black-Scholes method of option pricing) and that returns for options on extreme price movements are highly scalable, it should be possible to hedge against movement in any vector in the future solution space simultaneously. Let me offer a simplified illustration:
Oil/Dollar/Dow solution space:
Here is a solution space with three dimensions: dimension 1: NYMEX Crude Oil rise/fall, dimension 2: US Dollar rise/fall, dimension 3: Dow Jones Industrial Average rise/fall.
These three dimensions are an extreme simplification of the possible sets of future scenarios, but are useful as an example and because it is relatively simple to hedge against extreme movements in any direction from the status quo through out of the money options on established futures exchanges. In fact, I think that a multi-dimensional hedge can effectively address this solution space with only 3 options: crude oil call option (betting on extreme rise in price), dollar put option (betting on extreme loss of value), and DJIA put option (betting on extreme loss of value). As a hedge, this set seems to address most of the risk scenarios where a “conventional” investment in a career and home won’t pay off. Can you describe a scenario where one of these three options doesn’t pay, but the economic status quo doesn’t continue? This simplification isn’t meant to address sudden collapse scenarios where the markets simply cease functioning (an identified weakness, which we can also hedge against). But I have a difficult time explaining in advance how the economy could collapse while none of the following—spike in crude oil, drop in the dollar, OR drop in the Dow—occurs. Under most scenarios, at least one, probably two of the options pays off (e.g. Dollar drops causing a spike in the price of dollar-denominated oil but a rise in the numerical value of the Dow).
Sudden Peak: Oil prices will spike. IF they spike sufficient to cause enough demand destruction to actually fall, that will cause the Dow to collapse. It will likely be accompanies by either high inflation (dollar collapses) or deflation. While deflation is also possible, that would cause the numerical value of the Dow to collapse. Not perfect, but nothing is…
Now expand this multi-dimensional hedge beyond purely financial market considerations. Accept for a moment that the above hedge system is a perfect hedge against any movements in the financial markets (it is not). What could still cause it to fail? Two thoughts immediately come to mind: 1) collapse/conflict is so sudden that markets shut down completely, or 2) popularist laws are enacted that negate the hedge, say by penalizing people who “exploited” the dramatic market swings through options. Under scenario 1, the classic survivalist advice along the lines of “beans, bullets, and gold” may suddenly prove extremely valuable. Under scenario 2, hedges that operate outside the purview of established exchanges may suffice—again, perhaps gold or silver coins. Moving beyond the fixed game-rules of financial markets makes defining and addressing the future solution-space far more difficult, but no less necessary.
Of course, these are intended as hedges AGAINST the continuation of the status quo. You still need a viable plan if things continue as conventional wisdom suggests they will. So, here is a potential outline of a “complete” future plan. It also happens to be what I am presently doing. It is certainly imperfect, but its imperfections should be illustrative:
1. Job for the Status Quo: invest in/prepare for a job that will pay well under the status quo. Personally, I’m studying law, even though I already have a “good job.” I find it fascinating and actually enjoy the area that I hope to be working in—litigation/appellate work with a subject matter focus on energy law. That said, law is probably a terrible choice for most people, but I have been very fortunate thus far in that things are working out according to my master plan:) —as general advice nursing or engineering seem the most prudent. I already have an engineering degree, but I want to be involved at the nexus of anthropology, politics, and the future of energy (an odd combination, isn’t it?), so I have chosen law.
2. Plan for a resilient and flexible “End Game”: I hope to continue to practice law in a capacity that I enjoy for the rest of my life, but I certainly want to be in the position that this is a choice, not a requirement. Therefore I plan to invest some of my income in creating a flexible and resilient “end game”—for me, this is a sustainable, self-sufficient home for my family that will excel in future roles as disparate as a vacation home, retirement location, or a survival retreat. This will be my principal investment, as I think that it will most effectively hedge against the vast majority of scenarios for which there is no effective market hedge.
3. Financial hedge: If the economic status quo continues, the home described above will become my version of a 401(k). If not, my financial hedges are intended to ensure that I can still complete that plan. I plan to follow a variant of the oil-dollar-dow hedge described above—at least until I can think of a better system. I currently have long-term call options on oil and short term puts on the dollar. I think that an investment of roughly 5% of my income will be able to effectively hedge against most financial catastrophe.**
4. The Black Swan: While I think that this future plan effectively hedges against many possible future scenarios, and will increase the probability that I achieve my goals under a variety of scenarios, it is important to recognize that there is always the possibility of something totally unexpected happening that will derail all of these plans. That probability is likely much greater than most people anticipate. Some investment in stored food and water, gold, etc. is probably a prudent way to hedge against at least some unanticipated dimensions of the future solution space. Like a far out of the money option, investment in a few gold or siver coins or a shotgun is a small price, probably won’t be necessary, but has a highly scalable value in certain possible futures. A broad base of knowledge, fitness, and health may be even more valuable.
My intent here is not to slide into self-help or prophecy. Rather it is to suggest that, if you think you know exactly what the future holds, you are probably deluding yourself. If you are not preparing for multiple contradictory future scenarios, then you are not preparing but gambling. What is the optimal hedge—the simplest, cheapest, and most complete coverage against radical departures from the status quo? I’ve proposed the following set: crude call options, dollar put options, Dow put options, 30 days food and water and a shotgun. Call it a future first-aid kit. My proposal is only a starting point, and certainly imperfect. How can it be improved?
It is also worth pointing out that such a hedge is only viable if it helps to achieve a future end-game vision that functions under both the status quo and collapse. In some Mad Max future, 30 days of food and a shotgun is a start, a broad base of knowledge is even better, but the point of the hedge is to get ensure existing plans come to fruition. Taking out a loan now to create that end-game vision in the near future, and then hedging against scenarios that would make you unable to repay that loan over the long term might be (contrary to “conventional wisdom”) more prudent than saving to get there some day…
**This financial hedge is, unfortunately, a bit more complex than simply buying one of each of these three options. For now I’m not going to delve into the intricacies of coordinating the strike prices and expiration dates of multiple options necessary to create a smooth hedge against risk through time. The general advice, though trite, is that if you don’t understand how to invest in options, you shouldn’t invest in options.
Parting question: I think this is a viable methodology for creating an individual plan of action. Can it be extended to a broader, societal plan? Financial hedges tend to be zero-sum in nature, so can't serve as the basis for a societal hedge--would any societal hedges necessarily pay "fair value" for risk, and therefore make hedging against multiple, contradictory future scenarios impracticable??