Insuring your portfolio against a “black swan” event in the financial markets isn’t as easy as you’d think.
Black-swans events are rare — hence the name — but when they happen they are sudden, awful and unpredictable. The U.S. stock market’s double-digit percentage loss over the past three trading sessions presumably qualifies.
Most of us think that the same risk-reduction strategies we employ in “normal” times will also protect us from black swans. We believe it’s possible to dial portfolio risk up or down, depending on our tolerance. For example, we think that by pursuing a not-too-risky, not-too-conservative strategy, we can still enjoy the bulk of the market’s upside while also being protected from its black swans.
Risk analyst and author Nassim Nicholas Taleb, in his 2007 book ”The Black Swan,” argued that this belief is mistaken, since “middle-of-the-road risks” are not related in any straightforward way to the risks at the tails (extremes) of the distribution. A man whose feet is in the oven and head in the freezer is not OK, no matter what his average body temperature would lead you to believe.
Take the traditional approach to risk management, the 60/40 stock/bond portfolio. Over the three U.S. trading sessions through Monday, it produced a 6.9% loss (assuming the stock portion was invested in the S&P 500 SPX and the bond portion in long-term Treasurys).
In contrast to traditional risk-management approaches, Taleb recommended what he called a “barbell” strategy: “Your strategy is to be as hyperconservative and hyperaggressive as you can be, instead of being mildly aggressive or conservative.” One barbell strategy is to allocate the bulk of your portfolio to Treasurys and invest the interest you earn from these U.S. government bonds in S&P 500 call options.
To be sure, this strategy will still experience some short-term volatility. But because you’re only investing the interest you earn, you won’t lose money with this approach so long as you hold the Treasurys until maturity. And, depending on the options you purchase and the behavior of the S&P 500 SPX, you will participate in much of the market’s upside.
