Keeping in mind contingency risk

CIO Insights 3Q2026

We have for a long time been somewhat puzzled by the scant attention contingency risk receives in finance and investing, bar the insurance industry. We are concerned that the booming equity markets express undue indifference about major eventualities that do not immediately relate to the usual macro- and microeconomic developments of the day. By contingency risk, we mean the possible occurrence of rare events that may have a significant impact on asset prices and residual values. It encompasses systemically relevant dangers such as armed conflicts, political upheaval, natural disasters and weather phenomena, environmental degradation, disease, electrical grid failure and nuclear incidents. It also includes “modern” issues such as resource scarcity, misuse or malfunction of high-tech, as well as cyber-, hybrid-, and biological warfare. To be fair, contingency risk in an investment context should also include positive events, such as unexpected scientific, technological and medical breakthroughs, the removal of trade barriers or the cessation of war and geopolitical disputes. However, as deep value managers we admit being loss averse in behavioral terms—we care more about what can go wrong than what can go right.

There are understandable reasons why investment professionals tend to underrate or altogether ignore contingency risk. First, some analysts deliberately disregard them because they may be too hard to assess and the whole exercise therefore may not yield an intelligible answer. For example, how can a rare event be quantified in terms of probability, timing and magnitude? Are its effects permanent or temporary? What could be secondary or tertiary effects emanating from it, and how can they be measured? And would contingencies even matter if the risks in question were non-hedgeable and all assets affected in the same way? Second, some investors implicitly lump them into other risk buckets, for example when estimating country and equity risk premiums. Third, companies insure themselves against many types of risk and have force majeure clauses in their contracts, hence some contingencies are already covered at the corporate level. And fourth, there’s an agency problem. Suppose I’m a permanently pessimistic fund manager who always sees major non-diversifiable threats lurking around the corner. In this case the discount rates I apply to value assets will be so high that I will never find worthwhile investment opportunities, and my clients will go elsewhere to earn a decent return on their money.

It is thus tricky to establish a comprehensive treatment of contingency risk in the equity valuation process. Why, then, even raise the issue? Our point is that merely pondering such eventualities and possible ramifications makes us more careful investors at heart. It causes us to be extra selective in our search for potential investment opportunities, and conservative when it comes to the estimation of cash flow generation and discount rates. The resulting margin of safety serves, in part, to cushion the blow from any unknown adverse externalities that inevitably arise from time to time. This inherent wariness is an essential building block in the way we manage money, considering that our approach has never been designed to hold up better than others during a widespread downturn in share prices. To recall, our long-standing structural exposure to bargain issues in asset-heavy and cyclical industries, small- and medium-size enterprises and emerging markets may at times render our strategy even more volatile than the market as a whole.

Consequently, we believe that contingency risks should primarily be dealt with at each saver’s strategic asset allocation level. Common sense should always be the guiding principle: diversify among asset classes and uncorrelated investment styles; don’t put everything into high-octane investments; rebalance; avoid leverage; and don’t take rash or emotional decisions. Savers should moreover think about how high their portfolios’ weighting in equity index vehicles should be. Index funds are tools of allocation, not of pricing or valuation. They don’t reflect on contingency risk; to do so is each investor’s own responsibility.

What should one own when investing with contingency risk in mind, then? We suggest that such an asset allocation should aim for, if possible, a rolling “reserve” of three to five years’ worth of estimated annual household outlays in the form of cash equivalents and short- to medium-term fixed-income government securities. In addition, savings vehicles featuring annuity-type payout profiles are a helpful way to smoothen out return and cash flow streams over time. Whatever the specific tools chosen, building a robust financial fundament is key to coping with elusive but potentially far-reaching risk scenarios.

Sincerely,