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Investments Inc.

spacer October 2005

We frequently talk about our stock selections within the context of the risk/reward continuum. Our initial sell targets represent our best guess as to the size of the potential reward; in our efforts to manage risk, we search for the negative aspects of the enterprise behind an investment.

In the business world, derivatives are used on a daily basis to reduce risk for individuals and companies, and proponents believe they make markets more efficient. They can also be highly lucrative and pad the profits of banks. But the very ease and speed with which they can be bought and sold creates vulnerability to a devastating global financial meltdown.

Hedge funds are also supposed to help investors manage risk. Some might do just that, but overall, we're skeptical. The concept of a long-short fund, containing bets for good companies and against the bad ones, is intriguing.

But at what point do you end up betting against yourself, controlling risk by eliminating reward -- the equivalent of covering both red and black on a roulette table (and in the unlikely event of a double zero, as in the case of the Portus affair, the house wins it all).

Each of us balances risk against reward with every decision we make, in every aspect of our lives, from the mundane to the life-altering. On the larger scale, politicians and bureaucrats weigh the costs and benefits of decisions that affect us all, with an added dimension: they are often in the position of choosing between the public good and what is politically expedient.

Nowhere is this clearer than on the American Gulf coast, and particularly in New Orleans. The storm surge that inundated the vast majority of the city had been foreseen, most notably in an article, "The Drowning of New Orleans," that appeared in Scientific American -- in 2001.

In June 2002, a multi-part series in the New Orleans Times-Picayune also sounded the alarm bells about the Crescent City's vulnerability to an epic disaster caused by a hurricane, as did Popular Mechanics, National Geographic and PBS's series Nova.

In late June 2005, the Picayune reported that the two branches of Congress were wrangling over how much money to dole out to the body that oversees the National Hurricane Center.

The House wanted to cut the budget by half a billion dollars, prompting David Vitter, a senator representing Louisiana, to complain that "We are responding to storms after the fact. Instead of spending millions now, we will spend billions after the fact and lose as many as 100,000 lives in New Orleans."

Hmm, an ounce of prevention...

Since the risks were so apparent, why was so little done to mitigate them? One reason is the old question of how to allocate funding, given competing priorities. Nor did it necessarily help that the political landscape in the Pelican State is littered with corruption -- spending money there must have seemed like throwing good money after bad.

In recent weeks, the media have repeatedly noted that most of New Orleans lies below sea level; but rarely is that curious detail explained. One might well imagine that some French explorer, delirious from absinthe and malaria, found a hole in the ground and set up shop.

So, let's backtrack a few hundred years. The French built "Nouvelle-Orleans" on relatively high, dry ground, on soil left behind by the periodic flooding of the Mississippi River as it meandered in the direction of the gulf.

Over time, sedimentation added to the natural levees, building a barrier against the effects of flooding. Human hands, sometimes forced, built the walls higher still. The fetid swamps on the outskirts were drained, but growth was effectively hindered until the 1910s, when pumps were finally able to keep rainwater from collecting in the lower-lying districts.

The ground was now dry and fit for human habitation, but the fact remained that bedrock was buried beneath a layer of muck that varied in depth between several dozen and several hundred feet. This soil dried and compacted. In other words, as the Tragically Hip sang, "New Orleans is sinking."

The city's port has long been a vital transport hub, and canals were built to connect the river with Lake Pontchartrain to the north and to help carry rainwater away. But they are higher than the land they pass through, so they are essentially massive aqueducts, with levee walls holding back their water. Breaches in these canal levees resulted in the majority of the flooding and consequent loss of life.

Those who are eager to cast blame for the disaster have focused on a 50-percent cut to the U.S. Army Corps of Engineers' budget for levee augmentation. But according to those who predicted the catastrophe with such chilling accuracy, building the levees a bit higher or broader would have made little difference. Indeed, even before the famous flood of 1927, astute observers noticed that, as the levees got higher, so did the level of the river -- hardly the desired effect.

It is said that generals train to fight the last war. It's equally natural for leaders in government and business to focus on threats that are known and understood. In the case of New Orleans, this familiar foe was "Old Man River." But there was a greater, underrated, threat: the Gulf of Mexico, which has been marching north at an astonishing rate.

Hundreds of miles of channels have been dredged through the delta to accommodate the oil tankers that ply the waters between New Orleans and the gulf. As a result, saltwater intruded on marshlands, killing vegetation and increasing erosion.

Meanwhile, as the river's course has been gradually straightened and constrained, the silt that once replenished the marshlands and barrier islands now drifts far out into the deep ocean.

What's the big deal about losing wetland, unless you're some kind of nature nut or duck hunter? As destructive as a hurricane's extreme winds and driving rain may be, by far the most damaging force is storm surge: whirling winds bulldoze the surface of the ocean, creating a dome of water that washes inland.

Marshland is valuable because it holds back and absorbs the surge. Four miles of bog reduces the surge by one foot, so a healthy marsh 60 miles deep would provide protection from a 15-foot surge -- about what Katrina was able to kick up.

Though engineers have a pretty good idea of what needs to be done to restore the delta, it's not the kind of megaproject that delivers immediate bang for the political buck. Sometimes, a worthy project occupies the back burner till a more attractive impetus comes along.

Consider the Hoover Dam, one of the greatest engineering feats in history. It was originally proposed to control floods on the Colorado River; however, it was California's thirst for electric power and water for irrigation that brought the plan to fruition.

Elsewhere, it seems, reducing the risk to lives and property have been compelling enough to prompt government action. After floods killed thousands in 1953, Britain erected the Thames Barrier to protect London, while the Netherlands built the Deltaworks to shut out the North Sea.

Closer to home, the devastating flood of 1950 in Winnipeg resulted in the largest evacuation ever in Canada. In response, a 47-kilometre floodway was constructed. When the project was in its planning stages, it was dismissed as "Duff's Ditch" by Premier Duff Roblin's political opponents, who advocated dredging the river and building dikes instead.

Decades later, Roblin's vision has been vindicated and built upon -- the 1997 flood, a "once-a-century" catastrophe, nearly overwhelmed the floodway, so the current plan is to improve it, at a cost of $665 million, preparing it for the type of flood that might occur once every 700 years.

In New Orleans, there is brave talk of rebuilding. For many, given the sunk costs -- both financial and cultural -- deserting the city is simply not an option. But as callous as it might seem, there is a case to be made for abandonment: spending tens of billions of dollars on reconstruction as long as the systemic problems remain is just plain dumb.

(Our editor suggests that if you've ever had the fried green tomatoes at Upperline or heard Bob French on WWOZ-FM, you wouldn't question for a second the need to rebuild, but not even he thinks the pre-Katrina status quo is an option.)

To assess risk correctly means not only looking on the micro and short-term levels, but also the macro and the long-term. We often ignore the broader context -- at our own peril. Therefore, when we try to remedy one problem, unintended consequences often ensue.

Did the ouster of Saddam Hussein make the world safer, or did it actually turn Iraq into the planet's largest terrorist recruiting centre? Vioxx was used to reduce pain and effectively treat arthritis, but it increased the risk of fatal heart attacks.

The lessons are many, and they are simple. Risk cannot be eliminated, but nor should it be ignored. It can be managed, but not if one focuses on political gain or short-term expediency, or exhibits complacency.

Neglect, benign or otherwise, is a false economy. The ability to take the long view, even if it means suffering the slings and arrows of outrageous voters and party donors, is essential. These may seem like home truths -- yet they are too easily forgotten.

In any sphere, balancing the qualitative and quantitative aspects of decisions, along with short- and long-term impacts, is no easy task. The many factors that conspire to take our eyes off the prize make for a less-than-savoury gumbo.

We advise that copious quantities of the following ingredients be thrown into the pot: intelligence, visionary thinking, vigilance, and a sense of the broader canvas. You don't need to be Paul Prud'homme to recognize that as a recipe for success.

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