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Stock investing with black swan protection

104K views 84 replies 20 participants last post by  Covariance 
#1 ·
Quick background: Nassim Taleb believes in the need to hedge against "tail risk" or "black swans" -- you don't just invest in the index, but also carry some kind of insurance against sharp declines. He's an advisor at a hedge fund that uses this strategy, where they carry a small amount of insurance. Compared to standard 60/40 allocation, this allows them to carry a higher stock allocation and experience greater returns in good times. When the occasional crashes, their insurance pays off big time, boosting returns. This is described well in this video from Universa, where Taleb is scientific advisor:
https://www.youtube.com/watch?v=9mfnSM0k9jY

Then I ran into something interesting, that in 2012, this same hedge fund partnered with Horizons to introduce a Horizons Universa Canadian Black Swan ETF (HUT). The ETF was terminated in 2016, and I'd like to know why, but I'm assuming it's because they performed poorly and had insufficient assets under management to make it viable. If you look at the TSX chart, this ETF was introduced right at a market bottom right before a +50% index rally. Ha! The insurance + high MER + high TER probably caused a tremendous drag and people asked, why would I bother holding insurance and killing my returns?

In an old thread here at CMF, humble_pie theorized that the ETF will be a loser because Horizons doesn't do well at options trading. Personally, I wouldn't invest in a hedge fund that promises to do this either. Hedge funds have very high fees, and who knows how well they can implement a strategy.

In any case, I think Taleb and Universa's point is still valid: it can be a good idea to hedge or insure a portfolio against declines. And it's probably better to think about this with the market at all time highs, because insurance is so cheap (nobody sees the need for it). But obviously, it's tough to implement, as evidenced by HUT's failure.

Question for all: what methods do you use, or are you considering, for this kind of insurance or black swan protection?
 
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#2 · (Edited)
Here's what I do by the way. My overall goal is similar long-term return as 60/40 with less risk (less draw down).

My primary method: The permanent portfolio allocation. Here, bonds/gold/cash acts as the disaster hedge. In a really bad year like 2008, those assets soften the portfolio's decline, and you end up with spare money to re-allocate back into stocks. I showed some historical performance graphs over on this page. This method currently looks unattractive because of the poor recent returns from bonds & gold (or: the hedges are cheap). This image shows my PP return since I started using it, indexed to a starting value of 100 and currently at 105.
Text Blue Line Font Plot



My secondary method: Years ago, I developed a technical analysis technique to try to spot a weakening market. If it tells me to sell and get out, then I do. It does not "intervene" too often, so it hasn't cost me much return. Whether it actually intervenes at the right time so that I can avoid a market crash remains to be seen. I use this within my permanent portfolio allocation, and I'm hoping that either my primary OR secondary method will work. During strong periods of stocks, I will forego some returns. I am reasonably confident that either my primary or secondary method will protect me from big declines during the next crash / bear market.
 
#79 ·
My secondary method: Years ago, I developed a technical analysis technique to try to spot a weakening market. If it tells me to sell and get out, then I do. It does not "intervene" too often, so it hasn't cost me much return. Whether it actually intervenes at the right time so that I can avoid a market crash remains to be seen.
I was checking up on my crash-avoidance technical analysis and saw something very interesting. With the current market direction, it appears on track to give me a "sell" intervention signal this Wednesday... that's the day after the US election!

I got rid of my TAIL hedge but still listen to my crash-avoidance technical signal. If it does tell me to sell, I will slightly lighten my equity exposure... barely makes a difference in my asset allocation, but keeps me entertained. It's a little bit of "market timing" with a small amount of my portfolio.
 
#3 ·
Sounds like what I have been doing for the last 7 months.

1) Buy risky fast rising stocks

2) Protect myself by buying OTM puts

3) Defray the cost of the puts by selling OTM calls against the stock.

My rule, put no more than 1/10 of my portfolio into any one stock. And buy puts that guarantee I can't lose more than 1/10 of that. In other words my max risk on any one position is 1% of my account.

It's working pretty well so far. But my profits for the year could be wiped out by a market crash. This is not as bad as it sounds - there are years when the best investors in the business would be proud to announce that they lost no money and broke even on the year.

I come from real estate investing where nobody but a numbskull would neglect to buy insurance. Is insuring your house a waste of money? We all hope so. And most years it is. But on the off chance your house burns down you don't want to be without it.
 
#4 ·
I come from real estate investing where nobody but a numbskull would neglect to buy insurance. Is insuring your house a waste of money? We all hope so. And most years it is. But on the off chance your house burns down you don't want to be without it.
Glad you posted, I was thinking about you when I created this thread. My "secondary method" is somewhat similar to the T/A technique you posted earlier.
 
#5 ·
: it can be a good idea to hedge or insure a portfolio against declines. And it's probably better to think about this with the market at all time highs, because insurance is so cheap (nobody sees the need for it). But obviously, it's tough to implement, as evidenced by HUT's failure.

Question for all: what methods do you use, or are you considering, for this kind of insurance or black swan protection?

The method I use is the same as most other investors, and that's asset allocation, as it's probably the best and easiest hedging strategy. Fixed income provides the protection needed in a bear market and offers lower volatility overall. I see no other reason to add expense by using any sort of fancy hedging or black swan protection.

ltr
 
#7 ·
^+1 Like_to_retire.
I don't have the time or inclination to be hedging, using options or trying to time the market. Average market returns will suffice.
Let the companies I own run their business, let the market run its rollercoaster, I don't need to get off for many years and can pick the times I do.
 
#8 ·
james, with respect, you are a number mystic ... you aren’t alone, the search for the infallible investing theory marches on and powers a substantial portion of the internet devoted to investing

i suspect that in the case of the video presenter, and you, and most other people that the portfolio drag produced by the never ending search for the perfect hedge will cancel out its (the hedges) value over time ... we see it in the good and bad years that hedge fund managers deliver time after time

all of it involves predicting the future and nobody does that well

why not have a diversified portfolio, a good asset mix, a balance of growth and dividend stocks across most of the sectors, a healthy mix of bonds and most important of all ... enough cash to avoid a liquidity squeeze

your opportunity cost because of your cash and gold allocation to 50% of your portfolio is simply too high and i don’t have to look at any numbers to know that

for the average small investor, good diversification ... and liquidity ... are the much simpler keys to long term investing success
 
#10 ·
a tiny question for the folks who are so tranquil about a possible black swan financial collapse:

were y'll so calm like this in late 2008/early 2009?


(notice that these folks all tend to say they are well off) (notice how at least one maintains a cash dam that was - best i can recall - equal to 2 years' worth of expenses) (if that isn't a black swan protector then i don't know what is)

.
 
#20 ·
a tiny question for the folks who are so tranquil about a possible black swan financial collapse:

were y'll so calm like this in late 2008/early 2009?
For sure. I remember backing up a truck in 2009 for beaten down preferred shares. Nice profit a few years later.

(notice that these folks all tend to say they are well off) (notice how at least one maintains a cash dam that was - best i can recall - equal to 2 years' worth of expenses) (if that isn't a black swan protector then i don't know what is)
I certainly keep two years of expenses in cash. That's called asset allocation to cash. It's about 2-3%. This is reasonable insurance against any black swan event. Paying for insurance in the form of asset allocation is a far cry from buying Horizons Universal Canadian Black Swan ETF (HUT)

ltr
 
#11 · (Edited)
+1 ltr. Ditto here and for the same reasons you and OMO state.

j4b, just read a FP article today on 5 market doomsayers. Nassim Taleb was mentioned as per below:


Nassim Taleb

Taleb is best known for his 2007 book, The Black Swan: The Impact of the Highly Improbable, in which he warned about the inability to predict unusual events that have severe consequences. Certainly, he seems grounded, in that he says “you can’t predict what will happen” and we would agree to this completely as to the stock market, at least. His aim is to primarily sell books, but he has had some correct calls in the past. He did say that Donald Trump as president was no worry for investors, for example. Last August, however, he said that “a market crash was on the horizon,” quoting low interest rates and the fact that “you can’t cure debt with debt.”

HP, I'll bite on the rhetorical question. Put me in the group that also has a sizable cash position ~3 yrs+ expenses. The difference for me now versus '08/09 is I was 100% equities then and now about 60/40 as I'm retired, capital preservation more important, cash now earns more than bonds. So guilty if you consider that being prepared for a black swan. :biggrin:
 
#12 ·
+1 ltr. Ditto here and for the same reasons you and OMO state.

j4b, just read a FP article today on 5 market doomsayers. Nassim Taleb was mentioned


however, notice that the biggest bear of all - nouriel roubini - is missing from that list

it's kind of a weird list imho. Respected economist Mohamed el-Erian - bearish for more than a year - is also missing from that list. As is his former bond-master boss.

.
 
#14 ·
Hi:

I see investing as having seasons: Buy, sell, hold. The problem is in knowing what season one is in. A black swan is not a problem, but rather a very solid indicator that it would be buy season. The intelligent response is to then buy during buy season. No need to hedge something that is not seen as a problem.

Hboy54
 
#21 · (Edited)
The intelligent response is to then buy during buy season. No need to hedge something that is not seen as a problem.

Hboy54
That doesn't work if someone does not have enough cash to buy in the 'buy' season...and in particular, those in withdrawal mode without the 'cash dam'. Or one has to sell something out of another segment of their asset allocation to get the cash.

To respond to HP, I didn't 'freak out' in 2008/2009 due to a strong and well funded asset base to backstop relative 'tranquility'. Can't say I was a happy camper but like LTR, I was investing and tax loss selling during that period. I just happened to have a pretty good cash allocation at the time.

My 'black swan' hedging strategy is somewhat like LTR's strategy. I hold enough cash and cash equivalents that together with my small DB pension and dividend income, it will see me through a number of years of financial crisis. True, some dividends will get cut but I've taken a pretty significant discount to current investment income streams as part of my consideration.

Added: And I can cut back annual spending significantly if some really bad stuff happens.
 
#16 ·
99% of these doomsayers are spectacularly correct ... one time ... and never right again

but they wisely milk that one right call into consulting, speaking and book writing for many years after

and then many of them get caught in a reputation-trap where they are such notorious bears that they can never call a bull market !
 
#17 · (Edited)
The way I m protecting from the black swan event of the market bubble continuing higher for the next 10 years is to simply never put more on the table then I make from interest in GICs.

Been siting on the sidelines for @ least a year. Looking to put on a very small short position on next new high in the DJI with OTM put options in SPX Dec 2017,Dec 2018 & Dec 2019 between 1000- 500 strike & a larger short position near the top of a wave 2 correction after 5 waves down. Should probably skip the first short position though since I think the next top is going to be one degree larger then 1929 top a little concerned about catching the ABC rally as it will be fast & the 1st 5 down could be like 1929 crash though even faster so some big money can be made before the larger third wave
 
#18 ·
Just a little observation, you dont protect/insure paper with more paper.

A black swan event will undoubtedly be a liquidity event and there is no guarantee that it will pay out.

A true black swan event needs gold and land as hedge.

I suggest you read Jim Rickards - not a doomsdayer, but well on guard for system shocks. He interviewed european families who held their wealth for hundreds of years through war, famine and financial calamity and they didnt do it with ETFs.
 
#19 · (Edited)
"Rusty by your own admission this is *not* what you are doing in BABA, where you have posted in another thread that investors can collect 8% sure-fire returns in BABA by following your strategy."

That is not what I said at all. What I said was, that I am up 8% for the year and that the BABA trade is only one of several trades I have done. I never used the term 'sure fire'.

"let's look at the partial data you've supplied so far. You said you bought BABA in june/17. By a speculative piece of good fortune, the stock then rose nicely. Last month - roughly 2 months after the stock purchase - you then bought long BABA puts to protect your speculative gain."

I started buying BABA June 19 and bought it over a period of a couple of weeks. I actually started buying BABA in April but got stopped out in early June. This was one of the experiences that led me to start using protective puts as insurance. I have had the protective puts on since June. First I used ITM puts then changed to OTM when I figured out the ITM puts were too costly.



"there's nothing particularly unusual about this. Probably more than half of all cmffers - by conservative estimate - have nice gains in one security or another over the past 6 months.

it's a common occurrence, repeat 500 million times. One buys stocks. Stocks then rise. One looks around for an efficient hedge in case markets slide or - worse - collapse. Some folks sell. Some folks decide to buy puts.

bref, you benefited from a speculative rise in the risky stocks you were buying. Months later, as an afterthought, you bought some protective puts."

That is one way of looking at it. It's not what I said, not what I did, and not what I am suggesting but it is one way of looking at it.

"alas what you keep advocating though is some kind of fairytale sure-fire 8% return from an entirely different strategy that's known as a collar. Collars are long-stock-long-put-short call, all put on at the same time. They are designed to protect high dividends.

collars never result in big capital gains because the short call will always abort the long stock position & this will destroy the gain potential.

on the other hand, collars never lead to big capital losses either, because the put position offers a close-to-cost exit door."

Again, not what I said at all.

"rusty might i challenge you to find even a single collar position - what you are advocating as in buy stock today, buy put today, sell call today - that will ever amount to more than a 1.5-2.5% return over time.

plus let's not overlook that some collars actually lead to slight losses, which some professional managers believe is OK if the underlying dividend is a great big fat rich dividend .:peach:"

Fair enough. Would you like me to tell you about positions I already have on, that have proven profitable? Or would you prefer that I tell you about the next one I put on ?

Let me explain once more what I am trying to do.

1) Buy "Hot" stocks that have the potential to rise 50% or more in a year. You can find them at Investor's Business Daily. They publish a list of their Top 50 picks. Some of them are dandies.

2) Protect myself from loss by buying puts equal to the amount of stock. Try to keep the max loss to 10% or less, including the cost of the puts. Buy puts about 6 months out. I buy the put the same day I buy the stock.

3) Defray the cost of the puts by selling OTM calls against the stock. I will usually wait a few days before selling the calls if the stock is rising. I want to sell the calls at the end of a rise. Calls that are 2 weeks to a month to expire and with about an 85% chance of expiring worthless. If they go ITM be ready to roll them up and out. Worst case, I am forced to sell my stock at a profit.

That is the whole gag. Make money by buying stocks that go up. Buy insurance in the form of puts. Defray the cost of the puts by selling calls. It's a bit complicated but seems to be working so far. I can't guarantee it will work for you or anyone else. I don't know if it will keep working for me. But if the market bombs I know beforehand what my max loss is. It happens in BABA I have a 160 put on stock that I paid an average of under 150 for so I don't see how I can lose.

If you want more examples of the kind of stocks I mean, right now I own ANET ATVI BABA SQ TAL and YY. Previously I had positions in CRUS COR GRUB NVDA NFLX PI VEEV and others but got stopped out.

I hope to hold stocks longer than 6 months and will be happy to keep them a year or several years if they keep going up. If a position is working I plan to roll the puts at least 30 days before expiry. Selling the old ones and buying new ones farther out in time and with a higher strike.

I will post a trade I started a couple of days ago in a new thread if you are interested.
 
#26 · (Edited)
Are any of you shifting towards more conservative asset allocations with all the political talk of trade wars?

I'm still equal weights stocks/bonds/gold/cash -- but my cash cushion is included in that (not counted separately as people usually do).

I've chosen a conservative allocation because I may stop working in 2019 and I really don't want to lose any of my capital. This comes at the cost of performance: my allocation has returned 4.2% annually since I started using it, and I'm comfortable with this tradeoff -- more stability, less return.
 
#30 · (Edited)
A Super Cycle! That is the first bicycle I owned. I bought it in town at Canadian Tire purchased with my potato picking money. A 1 speed of course. I rode it up and down dusty country roads for many years as a youngster till I moved on to motorcycles at age 12. It was definately a worthwhile purchase.

Think though, if I had bought some CTC shares back then and had the good sense to hold them through thick and thin. I'd be much wealthier today.

My point is, over the long term succesful companies create value, grow, and profit. That is the reason to hold equities. What if they had failed? That is the reason to diversify. You could play it safe and own only their bonds instead. But they are never going to pay you as much as they believe they can earn reinvesting that money into their business. As a shareholder you benefit from that success.

If your holding period is truly long term, the crashes of the past soon look like mere blips in the rear view mirror.

If I have any regret as an investor, it might be that I was fairly conservative in my early years (only GIC's initially). Granted, investing in equities then was more difficult and expensive than it is now. And choices for diversification were limited or expensive as well.

Today, if I was starting an RRSP (or TSFA) that I wasn't touching for over 40 years as in my case, I would put it into diverse equities (e.g. an etf) and leave it there.

Super Cycle or not.
 
#31 · (Edited)
If your holding period is truly long term, the crashes of the past soon look like mere blips in the rear view mirror.
Most of us don't have the 50 or 100 year time horizons for this to really work.

The question becomes, how comfortable are you seeing significant declines like 40% to 70% drops in your portfolio? And how comfortable are you with low stocks returns over say 10 or 20 years? Both the TSX and S&P 500 had zero return for the first 12 years of this century, with lots of scary drops along the way.

Of course that got balanced out with higher returns later, but those 12 years were a big deal to a lot of people. What if the big drops happened just before someone retired? What if someone lost their job and needed the money during the down periods? And there have been even longer stretches historically, like 15 or 20 years.

How many of us have the ability to suffer through 10 to 20 years of zero stock returns (plus sharp drops)? I don't. When I was running my business, I watched my employment income crash at the same time the stock market crashed.
 
#35 ·
My black swan & bear market protection strategy.
What I don't do is use bonds. I am 100% stocks. If this was 1982 and rates were 15%+ I'd think differently as bonds would offer great income, and capial gains. Currently I see bonds as dead money. Low rates, and after tax and inflation, a losing proposition.

I buy stocks with tons of assets and good balance sheets. Upon the inevitable black swan/bear market my plan is to do nothing until the value looks utterly compelling, and technical analysis aproximates a bottom. Then buy more quality stocks on margin - as muich as I can stand and wait for the market to recover. Then sell enough stock to get off margin. I should make a bundle. I actually don't fear a bear market, I look forward to it. I made a killing in from 2008 - 2010 using margin.
 
#39 ·
i was about to ask you how much you lose by maintaining a large cash allocation since you need to be ready to buy and then i read again and see you are borrowing to buy at what you ... guess ... are lows

100% equities and the use of margin is about at the extreme end of the spectrum of investing risk ... i like a little bond allocation with my morning cereal and at my age don't borrow anything from anyone ... but i am not you :)

we need to set up an investing cage ring match and have you in one corner and james in the other :)
 
#36 ·
2008-2009 was a very short bear market by historical standards and the recovery was blazingly fast. I wouldn't count on that always happening. In your strategy, you might want to prepare for scenarios such as a stock index that falls and then stays low for 10 or even 15 years. The last crash & recovery helped train people to expect fast recoveries and relatively painless bear markets. Some people even forgot how bad the 2000-2003 bear market was.

We've basically been in a perpetual bull market since 1982 or so, and I don't think anyone really remembers what a true bear market is like. We have a strong equity culture today because equities have been incredibly strong for 36 years. I don't always expect this to be true.

By the way, I would argue that right now -- with stocks at all time highs and gold/bonds relatively weak -- is precisely when it makes sense to add hedges and protections.
 
#37 ·
i agree the 2008-2009 debacle was a short lived V trough that isn't all that representative of recessions in the last century. It would behoove those (me included) to look at other recessions to see how long it took to fully recover market highs. I certainly wouldn't, for a nanosecond, be buying what one might perceive to be market lows on margin. It could take a very long time to pay that margin loan off.
 
#40 · (Edited)
Regarding buying a crashing market on margin, have you taken into account that stock brokerages might curtail their lending during sharp downturns, tightening their margin lending?

This is one of the pitfalls of margin. It introduces parameters that are beyond your control. Now it's not just a matter of what YOU decide to do, but also what your broker decides to do -- and their problems are different than yours. Say the TSX crashes 30% and you start aggressively buying more. Then it crashes another 30% on top of that and you try to buy more on margin. Your broker might not play along. It wouldn't be surprising in such a scenario for them to tighten margin lending, actually forcing you into a margin call, and forcing you to liquidate when you really want to buy.

Changes to margin policies can also happen fast. How are you going to detect and respond to that? I like using margin for short term maneuvers but it's not a good idea for longer term positions. Unless you are going to be constantly on top of your brokerage for the next 20 years, and have enough cash on the sidelines to respond to margin policy changes, I seriously doubt this method will work.
 
#44 ·
Changes to margin policies can also happen fast. How are you going to detect and respond to that? I like using margin for short term maneuvers but it's not a good idea for longer term positions. Unless you are going to be constantly on top of your brokerage for the next 20 years, and have enough cash on the sidelines to respond to margin policy changes, I seriously doubt this method will work.
^ this ...by any measure, 100% equities and buying on margin at what are assumed are market lows is a very high risk game ... plus even though bonds don't anti-correlate with equities, they do enough so that they could be a much more secure source of cash for buys at presumed market lows ..
 
#41 ·
I've followed some funds that employ active hedging strategies and they mostly underperform.

Here is a long short/fund as an example:
https://arrow-capital.com/sites/def...re_Market_Neutral_Fund_Overview_-_F_class.pdf

It has underperformed the TSX on a 1, 3 and 5 year basis which is fairly spectacular.

I don't hedge and don't support such strategies. The best protection and the only free lunch is a well diversified portfolio. Diversify across economies, asset classes, sectors, etc. Don't try to predict the future and stay stoic.
 
#43 ·
Likely not asking me (12 years into retirement), but an example. Setting aside 'one off' large purchases, exceeding $30k in any given year, my annuity income (DB/CPP) covers 1/3rd of my annual cash flow needs, and investment income the other 2/3rds. I tap into original assets for 'one off' large purchases.

The investment income comes from (current mix):
35% Canadian equities (all dividend payers across 5-6 sectors)
34% US equities (~95% broad based ETFs)
15% International equities (all broad based ETFs)
4% Preferred equities
7% GICs/Bonds
5% Cash (MMF/ISA - brokerage)

Percentages vary by a few percentage points year to year depending on how/where I tinker with a holding. I'd like to boost International equity at the expense of Canadian equity, but not at a 75 cent dollar.

Plus I have some HISA cash sitting in a few online bank accounts that I don't count. Rule of thumb overall... 85% equity, 15% fixed income (for black swan purposes).
 
#46 ·
This is pretty interesting. Apparently there is a "tail risk" ETF named TAIL. It holds S&P 500 index put options:
Cambria Tail Risk ETF (TAIL) | Cambria Funds

The MER is pretty low. It's quite a bit more straightforward than some of the more exotic derivative ETFs; it's not a "daily movement" kind of ETF, so there is no chronic price decay like you see on many of the typical inverse funds.

Instead they hold a ladder of index puts and continually roll them over. I think I would rather buy this and get the automatic rollovers and management, than tinker with options myself.

Maybe TAIL is a good way to get your "insurance"?

20255
 
#48 ·
Interesting concept. The chart kind of mirror the VIX movements. In the recent market crash it has gone up 25% from the lows in January, which approximates the market decline. It does not seem to have an uptrend, so one has to aggressively rebalance or trade it. There is a small downtrend at the end of 2019, when the market was making new highs.

If one does a 50/50 with stocks, the portfolio will be protected from severe losses (and no need for bonds), but overall returns could suffer if there are losses on the TAIL side. On the other hand, one could lever it up, given the downside is limited. The rebalancing bonus could be substantial.
 
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