Beware of the butterfly effect
Even seemingly trivial daily expenses can add up to a huge capital loss in the long run
The global Covid-19 pandemic has affected nearly every sphere of life, including the markets, which have been on a rollercoaster ride since at least the beginning of March 2020.
And though scientists and researchers have warned for years of the potential danger of a superbug or novel virus, nobody expected just how dramatic the economic and social fallout would be.
Economists use various terms to explain phenomena that affect the stock market. Covid-19 would undoubtedly be called a “black swan event”. This term is based on an ancient saying that presumed black swans did not exist — until they were discovered in the wild. In other words, it’s an event that comes as a surprise at the time but is easier to rationalise with the benefit of hindsight.
We’re not talking about black swans today, though. When it comes to personal finance, there’s another effect that is much more subtle, but which also has the potential to wreak havoc with your portfolio — the butterfly effect.
What is the butterfly effect?
The term was coined by American mathematician and meteorologist Edward Lorenz, who asked — metaphorically — whether a tornado in Texas could be set off by the flap of a butterfly’s wings in Brazil. Lorenz was attempting to convey the idea that a complex system is unpredictable, and a small variance in the initial conditions can have a profound effect on the system’s outcome.
As embraced by popular culture, however, the term has been twisted slightly to convey the notion that a seemingly minor action can have serious and far-reaching consequences. This idea has been about in folklore since at least the 13th century, and it’s something we all know intrinsically. Understood in this context, here’s how those delicate butterfly wings can affect your finances:
Factor in uncertainty
On October 19 1987, stock markets crashed about the world. This later became known as Black Monday. It started in Hong Kong, before spreading to Europe and the US, where the Dow Jones lost 22% of its value in a single day.
Weirdly enough, Black Monday wasn’t caused by any significant external event. Rather, the crash was retrospectively attributed to errors in trading software, which prompted snowballing sales as the markets declined.
If something as “insignificant” as a software error can trigger worldwide pandemonium, it means nobody can predict the future with any degree of certainty. And it’s pointless to try.
Instead, you should rather include some defensiveness in your portfolio to minimise the risk of capital loss at any point in time. There are many ways to do this: you can choose to invest in less risky funds, you can rebalance your unit trust portfolio, you can diversify your investments across all sectors and regions, and you can hold a portion of cash, or cash equivalents, as security in the event of a downturn.
Take note of small expenses
The butterfly effect also applies on an everyday level, especially when it comes to expenses that seem trivial. That cappuccino you buy every morning on your way to work? The croissant from the cafeteria at 11am? That punnet of exorbitantly priced artichokes from the deli aisle in Woolworths?
We’re all guilty of spoiling ourselves every now and then, but it’s important to be aware of your spending so it doesn’t get out of hand. Those innocuous daily expenses can add up to a huge capital loss in the long run. To make matters worse, it’s not just the sum of all those cappuccinos; it’s also the loss of the potential compound growth on the accumulated daily amounts.
Ask for help
The butterfly effect should remind us to be cautious in our financial decision-making, whether it’s opting for a more conservative investment approach to mitigate the effects of a market downturn, or taking note of small expenses that can add up in the long run and threaten financial stability.
The lockdown period we find ourselves in is a perfect opportunity for some financial introspection. Use the quiet time wisely, and you’ll come out the other side stronger and more motivated than before. This is much easier said than done, of course. If you need assistance or guidance, enlist the help of a professional adviser — ideally one who at least holds the certified financial planner accreditation and who will decipher the jargon and make sure your savings are as healthy as can be.
Schedule a video call or send an e-mail — most planners are working remotely and will be all too happy to help.
• Swart is a director of Autus Private Clients and Financial Planner of the Year 2019
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