Weathering Financial Storms: Navigating Tail Risk With Confidence

We spent the better part of a decade discussing whether the Fed and world banks would move interest rates to 0% or even negative to keep economies chugging along. But then a virus quite literally shut down the global economy with 114 million job losses worldwide. The shock of those lost working hours was four times greater than that of the global financial crisis. Suddenly, without warning, interest rates were among the least of our problems.

Tail risks (commonly referred to as black swans thanks to the work of Nassim Nicholas Taleb) are characterized by their extreme nature, unpredictability, and the substantial impact they can have on investment portfolios and the overall economy.

This unpredictability in the financial markets leads to the black swan paradox: No matter how remote the possibility, investors cannot rule out events just because they haven’t seen them before. Because sometimes, stuff just happens.

Imagine your investment portfolio as a ship navigating the tumultuous seas of the financial market. While smooth sailing is the aspiration, a storm or rouge wave can arise suddenly, posing a threat to even the most well-constructed plans. This is where tail risk hedging comes into play.

It's not about avoiding risk altogether. It's about strategically mitigating the impact of extreme, unforeseen events that could capsize your financial voyage. By implementing a carefully crafted tail risk hedging strategy, you're essentially fortifying your portfolio against worst-case scenarios while preserving the potential for growth.

Good Defense Leads To Good Offense

Strategic risk mitigation is about reducing systematic risk in a portfolio through asset deployment that is thoughtfully evaluated rather than simply letting dynamic market activity alone dictate your portfolio results.

Contrast this with a tactical allocation which is an attempt to reduce systematic risk by actively moving in and out of certain ‘safer’ allocations, with the lofty goal of avoiding the opportunity cost of that safety when the markets are up.

Such a tactical approach to risk mitigation is a dichotomous one. Sometimes referred to in the industry as moving the portfolio between “risk on” and “risk off.” It’s analogous to buying insurance, later canceling the policy, then buying insurance again. Doing this cost-effectively, by definition, requires market timing and the ability to accurately forecast the near-term.

Effective risk mitigation, however, should never require forecasting. In fact, we seek to mitigate risk precisely because the future is inherently unknown and unknowable. If we could accurately predict the future, we wouldn’t have risk to mitigate!

All risk mitigation strategies ultimately require a tradeoff between the degree of loss protection provided (stuffing cash in a fireproof vault provides a lot of protection), versus the opportunity cost of allocating capital to the protection rather than to the rest of the portfolio (the vault also provides zero growth).

Asset Allocation

A 60/30/10 (stock/bond/cash) portfolio allocation is a simplistic example of a strategic allocation to mitigate risk, specifically the risk that the stock market drops at a time when you need to withdraw money.

A tactical approach might say I’ll start with 60/30/10 then when I feel the market turning, I’ll move to 80/20/0 or 20/60/20 or whatever the flavor of the day is. Unfortunately, this requires market timing and accurate forecasting which as we noted above, is highly unlikely.

Therefore, the better we are at designing and implementing our strategic, cost-effective risk mitigation policy, the fewer tactical levers we will need to pull on, and the better off we will be.

Portfolio Diversification

Another strategy to mitigate black swans is to diversify not only between asset classes (e.g. stocks and bonds) but also within asset classes. For example, rather than picking a handful of individual stocks, consider investing in a broad-based index fund that holds hundreds of individual stocks. (For more on diversification, see my previous article here).

More Exotic Strategies

There are other risk hedging strategies such as purchasing put options or other derivatives that provide insurance against extreme market drops. While effective, these strategies can come at a high cost due to the premiums associated with options and the ongoing maintenance required.

The message from all of this is that we are not attempting to raise our compounded return by taking greater risk. We are attempting to raise our CAGR over time by lowering the effect of risk—that nasty tail risk with the catastrophic aftermath.

Successful Investing Isn’t About Waiting For The Stormy Seas To Calm. It’s About Learning To Ride The Waves.

Our risk mitigation strategy should allow us to weather any storm—including no storm at all. We strive for a reasonable return during calm weather with the ability to shelter us from the effects of the tail risk storms that unpredictably but invariably arrive.

Arguably, tail risks are the only risks that matter since they are the kind that can destroy your capital base and knock you out of the investment game permanently.

If the stock market were to suddenly drop 30-50% in the near term, are you and your portfolio prepared to ride it out? If not, today is a good day to reevaluate your black swan mitigation strategy.

Our wealth accumulation voyage is a long one, and in order to reach the sunny shore of financial freedom, you first need to survive the storm.

As always, invest often and wisely. Thank you for reading.

My new book, Wealth Your Way is available on Amazon, and consider subscribing to my free newsletter.

The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.