Should you protect your portfolio against black swan events?

By: ispeculatornew
Date posted: 08.04.2010 (4:00 am) | Write a Comment  (3 Comments)

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If you are not familiar with black swan events, the you clearly missed out on one of the great reads of the past decade. Nassim Taleb’s book looked into pricing of rare events. The basic theory was that financial markets underestimated the probability of extreme events. Markets are often analyzed through complex models that help calculate the probability of various events. The objective of course is to get the most accurate pricing of financial instruments by calculating not only the estimated final price but also the entire range of possible outcomes. The book was already a major hit prior to the crisis that hit the world markets a few years but when everything seemed to collapse, it became a “Must Read” book.

How was the black swan theory validated?

A couple of years ago, when credit started beginning tight, many simultaneous events occurred that were “impossible” based on almost all economic & financial models. What were the odds that Bear Sterns & Lehman Brothers would both fail and force the Fed to move in to avoid the collapse of the entire financial industry? Sure, a few investors saw some of those events as possibilities and they made incredible amounts of money because those were deemed not possible by the other 99.9%.  A strong reaction by governments all around the world helped calm the markets and while we are far from out of the woods (many still believe a double dip will occur), the catastrophic scenarios feared not long ago are now more or less a thing of the past.

Investor attitudes have changed

The pain for many investors was so important that they are now still anxious about getting involved in the markets again. Slowly, these institutions and individuals are putting back their money into play but at the same time they are looking for ways to protect from the next catastrophic event, the next Black Swan. Of course, depending on every investor, what is described as a catastrophic event can be quite different. The other problem is that since there is so much fear in the current markets, implied volatility remains much higher than it was before the start of the crisis which makes it very expensive to protect against catastrophic events. But let’s say you did want to do just that, how would you do it!

Determine your own catastrophic event

Seems like it’s obvious but it’s not. For the long & short trades that we do on this blog, the exposure is very different from insurance companies or other individual investors. The main exposure that investors have is “long market”. That means that in almost all cases, you probably have long positions in market funds or ETF’s that would decline in value in the case of a market collapse. If you are part of that group, you have a fairly similar situation because many possibilities exist to protect yourself against a market collapse.

Alternatives

The reality is that there are many different ways to “hedge your portfolio” against so called catastrophic events. There really is no limit and in fact many large institutions have such products created customized to their exact needs. Unless some of you have a few millions in your bank account, that is probably beyond the realm of possibilities.. In the event that your exposure if “long stock market”, the main possibilities are:

Inverse and leveraged inverse ETF’s: This solution has gained popularity but I think it’s important to be clear what you are looking for because in a long term hedge such as the one we are currently trying to hedge (unless you have some scientific way of knowing the date it will happen if you do, contact me.. ha ha ha). So no, this is probably not the best solution. It will prove expensive and ineffective.

Options on futures: While this solution is slightly better, the fact is that trading futures (and futures options) is far more risky and complex than most investors really want to get involved in. Also investing for longer term maturities is not as easy with futures so I would avoid this solution

Equity options on ETF’s: Many ETF’s track the S&P500 and the most liquid one is surely SPY, the biggest ETF in the world. Thanks to that, options on SPY are very liquid even for longer term maturities. The problem remains, as discussed earlier, that implied volatility is quite high right now which makes buying “insurance” a lot more expensive than 2 years ago. I still decided to take a look at some possibilities. As of last week, I took a look at buying “Put Options” on SPY, which would gain value if the US stock market crashed.

I decided to take a look at what effect spending 2% of my portfolio (2,000$ in this case) would have in the event of a market crash. Take a look at the data and maybe more easy to understand is the chart:

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As implied volatility diminishes, the “cost” of insurance diminishes making the efficiency of this hedge more efficient. As you can see, right now

Conclusion

So personally, I think it is too expensive right now to buy this type of insurance given the cost-benefit, but would love to hear your opinion about it. Are you hedged in any way if the market tanks again? Have you looked into these or other ways of getting it done?

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3 Comments

  1. Comment by The Financial Blogger — August 4, 2010 @ 9:19 am

    I wouldn’t protect myself against something that will probably not happen for another good 10 years (how many black swan can we hit in an investor life?) and that will probably won’t have much importance in a long term investment portfolio.

    People who invested back in 2004 show a positive yield only 18 months after the big crash so it’s not worth it in my opinion.

  2. Comment by IS — August 5, 2010 @ 8:22 am

    @TFB – True that it might not happen again for a while but the reason it is so expensive right now is because the perceived risk a re-dip is very high

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