Help minimize risk by rounding out your portfolio's edges.

Watch Out For Square Windows2On January 10, 1954, BOAC Flight 781 was on its way to Singapore from London when it stopped to refuel in Rome. It had only been flying for twenty minutes when it exploded in mid-air. All thirty five passengers onboard died. It was the second deadly airborne crash of this particular aircraft design, the de Havilland Comet, to occur in just over one year. The crashes eventually prompted national investigations.

What had caused the planes to explode? At first, foul play or mid-flight fires were suspected. Eventually, however, investigators concluded that the crashes were most likely a result of metal fatigue in the airframes, a result of one fundamental design flaw: the Comet had square windows.

Unlike airplanes today, which have oval windows, the Comet’s square design created what engineers refer to as stress concentrations, areas that are more likely to break under pressure. When the engineers of the Comet finally identified the problem, they swapped out the squares for ovals and the planes flew safely. The oval designs turned out to be more resilient because, with a circle or an oval, the stress is distributed to various points around the rounded curve, rather than on one sharp corner.

In investing, it pays to watch out for the square windows in your portfolio.  These are the areas that represent the “sharp corners,” i.e., points of stress concentration that could break when times get difficult. These sharp corners can be related to the specific stocks you hold or the overall weight you have in one particular sector or geography. It’s important to go through your portfolio to smooth out these edges.

Rounding out the edges in investment portfolios is an ongoing process. It is also, unfortunately, not as simple as it sounds because it’s not always easy to spot the square windows. Often, we don’t realize we even have them because of our assumptions about the way the world works. For example, for most of the last decade, analysts talked about peak oil not $40 per barrel oil. And the Canadian dollar was rising. Canadian investors in 2012 may not have realized they had an unbalanced exposure to oil prices at all. In fact, many probably felt confident they were safe given that their investments had been on such a “winning” streak.

In our experience, it is easier to round out the edges in our portfolios when we routinely review our ingrained beliefs about the world – and turn those beliefs on their heads. For example, what if the Canadian housing market implodes? What if China has a hard landing? What if current central bank policies blow up our insurers and pensions? What if they turn out to be effective? These kinds of questions keep us on our toes and help guard against tunnel vision.

Square windows within a portfolio are problematic. Routinely rounding out the edges may help to reduce your exposure when the world moves in unanticipated and unusual directions… as it inevitably does.

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