Yesterday I caught my kid running down the middle of a long flight of stairs, nowhere near the handrail. I told my kid that if she fell she would have no way to stop herself and would probably smash her face or something.

Her response: “I do it all the time…nothing has ever happened before.”

At that moment, I realized this is a very common attitude among adults towards potentially catastrophic risks:

  • People don’t wear their seat belts because they think they’re good drivers and have never been in an accident.
  • People don’t save their money because they’ve never been laid off and think that if they were they could easily find another job.
  • People don’t wear bike helmets because they’re careful and have never wiped out.

As a DumbWealth reader, I want you to think differently.

Unfortunately, some bad things only have to happen once in your life to ruin you. One car accident, one major change to your employment prospects, one tap by a passing car can devastate your life. Sure maybe the odds are in your favour, but by thinking these things could never happen to you you’re gambling with your life, wealth and happiness.

Think about it another way. If you were to get into an accident without wearing a seatbelt, become a paraplegic and later found out you would have been fine if you had only worn your seatbelt, would you have any regrets? Probably.

People take low-probability but catastrophic risks because they focus on the odds and not the potential outcome. Just because something has never happened, it doesn’t mean it never will. There are no ‘do-overs’ for when a low-probability but catastrophic event occurs. Probabilities don’t care that you were right 99% of the time.

Moreover, many people believe they have more control over their lives than they actually do. Unfortunately, even the most skilled motorcyclists can be nicked from behind by a distracted driver. Within the past 3 years alone, I’ve personally known two motorcycle riders that died in relatively minor accidents that weren’t their fault. Both were part of a motorcycle culture that believes careful riding can prevent accidents. The reality is the destiny of even the most careful motorcyclist is actually in the hands of all the other drivers around them.

People also take low-probability but catastrophic risks because the warnings are mostly third-hand. People don’t often have friends or family who have been through such events and can serve as a direct warning. This is partly because these events are rare, but also because when they do occur often the victim is no longer alive (or mentally capable) to spread the warning.

This isn’t just about motorcycle riding and running down stairs. People also take potentially catastrophic risks with their finances.

Many people ignore the big risks that could result in devastating losses. Instead, they focus on the potential gain or the probabilities, as if they were buying a very expensive lottery ticket. However, they often fail to anticipate the impact of a bet gone wrong.

True, it is unlikely that any particular company goes bakrupt. But if it does, your investment may be wiped out – a catastrophic loss in anyone’s book.

When investing, you need to assume that you know less than you think. You need to be less confident in your bets, and therefore invest smaller amounts in each investment. Ideally, you also need to spread your money across risk factors as well. Diversification: that’s the DumbWealth way.

Over the years, I’ve personally learned my lesson. I’ve had many ‘sure things’ crash and burn. My saviour was always diversification.

Spread your money across many investments, many asset classes and many risk factors, so you can live to fight another day when you inevitably are wrong about one assumption or another, and so you’re not crippled by an unlikely, but catastrophic, event.

Even if you have a long winning streak , don’t forget that its all a gamble. Don’t start to think you’re some kind of investing genius. More than likely your success is due to luck…and luck runs out. People that spend their entire careers trying to outsmart the market fail. So what makes you so especially talented?

Bottom line: diversify because you’re not as skilled at avoiding low-probability but catastrophic events as you think.

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