Black Swan Secrets: Tactics to Navigate Tail Risk
Protection don't come cheap!
Pity the black swan…
For centuries, it lived obscurely among the pages of philosophy books penned by David Hume, John Stuart Mill, and Karl Popper.
But thanks to the popularity of Nassim Nicholas Taleb’s The Black Swan (2007), it appears almost daily in the world’s financial pages.
Here’s the origin of this colorful metaphor.
In the Middle Ages, Europeans believed that all swans were white.
Nothing they had ever seen over hundreds of years contradicted this belief.
That is until a Dutch explorer in 1697 discovered that Western Australia was home to black swans.
So what does a “Black Swan” have to do with investing?
As Taleb defines it, a “Black Swan” event is a rare, high-impact, and unexpected event that changes everything.
It’s the market crash that wiped out 22.61% of the S&P 500 on October 19th, 1987.
The fall of the Berlin Wall in 1989 led to the collapse of the Soviet Union.
It’s the two planes crashing into the World Trade Center on September 11th, 2001.
In financial markets, Black Swan events are also called “tail risks.”
Specifically, “tail risks” occur when financial markets fall unexpectedly fast and hard.
Because these sharp falls happen more often than predicted, the tails are “fatter” than based on the normal distribution (Gaussian) bell curve you find in finance textbooks.
Let’s look at the numbers from the U.S. stock market.
A three standard deviation event - daily move of plus or minus 2.92%-
has happened 229 times from 1950 to 2016.
That’s almost five times the expected 44 occurrences based on a normal distribution.
You’d expect a five-standard deviation (less than one event out of 1.35 million) to occur once every 6900 years.
Yet, the U.S. stock market has suffered 50 five standard deviation events since 1950.
The lesson?
Financial markets are much more volatile than finance textbooks predict.
Why You Should Worry About Tail Risk
It may seem like an odd time to worry about a market collapse.
As I write these lines, the S&P 500 will likely end the year near a record high.
But sharp market corrections are always a surprise.
December’s choppy market was a reminder that stock markets don't go up without a hitch.
The U.S. stock market is expensive.
The Shiller Cyclically Adjusted PE ratio or CAPE stands at 38.35 %.
That’s almost twice its long-term average of 17.19%
Of course, neither stretched valuations nor an aging bull market guarantees a market crash.
But the odds are no doubt higher,
So, how can you protect yourself?
You can buy options that rise in value when the market tumbles.
I see two challenges with this approach.
First, managing a portfolio of put options is challenging…even for someone who does it for a living.
Second, seeing the options you buy expiring worthless month after month is not for the faint-hearted.
The drag on your returns exacts a high psychological toll.
Here’s the good news.
Today, an Exchange Traded Fund—The Cambria Tail Risk ETF (TAIL)—implements this strategy for you.
Specifically, TAIL invests about 5% of its assets in a portfolio of out-of-the-money put options on the S&P 500 and holds the rest in 10-year U.S. Treasuries.
Both Treasuries and put options tend to rise during a market crash.
Like any form of insurance, you'll lose money when the market is rising in most years.
Cambria spends roughly 1% of the fund's assets on purchasing put options over rolling one-month periods.
Put another way, the "insurance" costs you about 1% monthly.
But throw in the price of missing out on the S&P 500’s rise, and the cost of holding TAIL almost doubles.
TAIL versus the S&P 500
If you had bought TAIL five years ago, you’d be down 43.2%
Over that same period, the S&P 500 has risen 86.5%
Meanwhile, the price of TAIL has fallen by over 17%.
No matter how you slice and dice it, that’s an expensive insurance policy to protect your downside.
What’s my recommendation?
TAIL isn’t a product I would “buy and hold.”
Invest in TAIL only when you believe- for whatever reason- a crash is imminent.
But for now, I’m not buying what TAIL is selling.