It has been a while since I reached out through these emails, but I found something which inspired me to write again.

In January, I read this article on a disastrous NFL bet. The Los Angeles Chargers were up 27-0 on the Jacksonville Jaguars as the first half ended. With a Chargers win seemingly assured, one investor decided to place a US$1,400,000 on their victory.

The Jaguars mounted a Viking comeback, winning 31-30.

At the end of the first half, the odds of a win for Jacksonville were low. So low, that our unlucky gambler only looked to gain $11,200, 0.8% of their bet. They probably thought this was an easy 11 grand.

In the investment world, accepting a very unlikely risk with a potentially cataclysmic outcome is often referred to as "picking up quarters in front of a steamroller".

This term was famously used to describe Long-Term Capital Management, also known as LTCM. Their strategy was highly leveraged and involved frequently trading bonds, making small gains on each trade. The risks of something happening in bond markets was small, but due to the amount of debt used, a black swan event could spell disaster for the gargantuan $5B fund.

The event came, with the Russian government defaulting on it's debt. The collapse of LTCM's fund was so severe, the US government feared it could spark a financial crisis, stepping in with a $3.65B to bailout the company.

This kind of downside risk, where the odds are low but outcomes severe, are not unique to investing and gambling. This risks are the reason insurance exists. The recent flooding illustrates this well, where a 1 in a 100-year event  (possibly a 1 in a 1000-year) caused wide-spread destruction. Insurance exists for these events, which are unlikely yet potentially devastating.

Unfortunately for investors, most investments don't have insurance, so how can we manage these risks?

Holding a share in a single company, or even a portfolio of a dozen shares, introduces a considerable downside risk. Even well established companies can fail (think of Enron, Bear Stearns, Lehman Brothers, and more recently FTX). When they do, that could represent a large part of an undiversified portfolio.

Less risky investments, such as bonds and term deposits, still carry these risks if not diversified. A company with a AAA credit rating has a 1 in 600 chance of default over 5 years. The odds of losing capital with a bond from such a company is low, but why accept that risk?

Diversification minimises the effects of any given company failing. The portfolios we build for clients have more than 8,000 holdings. Although some of the companies we invest in may fail, the impact is negligible and will be offset by other companies performing well.

We often say, if you have 10 cows and one doesn't return in the evening, you would notice. If you had 8,000 cows, I don't think you would be stressing.

Inexperienced investors often believe including shares in their portfolios introduces the risk of "losing money". By diversifying, this is no longer a concern. The true risk of investing in shares is idiosyncratic risk, which cannot be diversified away. Some market events will affect all the shares in your portfolio. When accepted, it is this risk for which investors expect to be rewarded.

The impact of the sports bet mentioned above is clear. If it doesn't pay off, the gambler loses their money. The same goes for LTCM's high risk strategy or buying a single share or bond.

The impact of a market event is temporary. We know markets always recover. The risk is your portfolio may fluctuate in value considerably, often at inopportune times. We manage this risk by choosing the right mix of investments for the investor and taking a long-term approach.

Can we learn anything from the examples above? First I would say that the impossible can happen. When it does, you do not want to be on the wrong side of a big bet. Secondly, through diversification we can rid ourselves of these risks, so why accept them at all?

Lastly, it is important to remember the risk associated with a diversified portfolio impacts us periodically. Through proper planning, we can be placed to benefit from these risks long-term.

I would also add, maybe avoid the TAB when it comes to the NFL.