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Why You Need to Watch Out for The Butterfly Effect

Posted On: Saturday, December 3, 2022

Why You Need to Watch Out for The Butterfly Effect

Covid-19 has upended almost every aspect of our lives, and it continues to do so.  We all know now when we travel that there may be havoc at some airports, as the airlines are understaffed.

The markets, meanwhile, continue to be taken on a veritable rollercoaster ride. Scientists and researchers have long warned of the havoc that could be wreaked by a novel virus. But most of these predictions centred around health issues and very little thought was given to the potential economic and social fallout.

Covid-19 is a classic example of a “black swan event”. The term originates from an ancient belief that black swans did not exist…until they were discovered in the wild. A black swan event is one that catches you completely off guard but is fairly easy to understand with the benefit of hindsight.

Which brings us to the butterfly effect. It’s not nearly as dramatic as a black swan. But, in the world of personal finance, it can cause just as much chaos.

I’ve heard the term but what even is the butterfly effect?

The term originated from the work of American 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. His example was meant to hammer home the fact that complex systems are incredibly unpredictable. His weather models showed that a tiny variance in the initial conditions could result in an entirely different end result.

In popular culture, however, the term has come to stand for the notion that what seems to be a minor action or event can have dramatic and wide-reaching consequences. So, using the popular definition of the term, here’s how the barely perceptible flap of far-off butterfly wings can affect your finances.

Expect the unexpected

Few could have predicted the events of 19 October 1987, a day we now refer to as Black Monday. A market crash that started in Hong Kong rapidly spread to Europe and the US, where the Dow Jones lost 22% of its value in a single day. Unlike many other crashes, Black Monday wasn’t the result of some major global event. Instead, a post-mortem revealed that the crash had been caused by errors in trading software which precipitated an avalanche of panic-selling.

While some might say we should have seen Covid-19 coming, Black Monday serves as a reminder that not even the brainiest boffin can predict the future with any degree of certainty. In fact, it’s pointless to even try...

Instead, you should focus on risk management through asset class and geographical diversification. Having investments in different asset classes is a great way of reducing risk in your portfolio. While investments from the same asset class are positively correlated (i.e. their values move in the same direction during investment cycles) investments from different asset classes can behave differently.

And this is before we’ve even got started on the benefits of geographic diversification – South Africa comprises just 1% of the global economy, so you’d be crazy to put all your investment eggs in this basket.

Take note of the little butterflies in your life

While there’s nothing you can do about some butterflies in Mexico or Mauritius, you’d be surprised how much control you have over other butterflies. Take, for example, seemingly minor everyday expenses like buying lunch from the gorgeous Italian deli near work instead of bringing a healthy homemade sandwich.

While we shouldn’t feel bad about spoiling ourselves every now and then, it’s important to keep tabs on your spending to make sure it doesn’t get out of hand. Taken together, all those piffling day-to-day splurges can add up to a massive capital loss in the long run. Especially when you factor in the compound interest you’d have earned from investing the money in a unit trust instead of a BLT!

Seek professional advice

When all’s said and done, the butterfly effect is a reminder to be careful and considered in our financial decision-making. This might mean responding to a market downturn by adopting a more conservative investment approach or trying to minimise small daily splurges which can add up over time.

The butterfly also underscores the importance of embracing lifelong learning. It’s never too late to learn about how the markets work, to understand the immense value of diversification, and to reflect on your own behaviour to make the little changes that will have a significant impact on your financial future.

Of course, this is much easier said than done. Which is why it’s a really good thing you’ve got a professional financial adviser in your corner. Our door is always open, contact us!

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