It’s not as simple as you may assume to protect your portfolio from a financial market “black swan” event.
As the name suggests, black-swan events are uncommon, but when they do occur, they are abrupt, terrible, and unpredictable. Presumably, the double-digit percentage decline in the U.S. stock market during the last three trading sessions qualifies.
The majority of us believe that we can avoid black swans by using the same risk-reduction techniques we use in “normal” times. Depending on our tolerance, we think we can adjust the risk of our portfolio. For instance, we believe that we may still benefit from the majority of the market’s upside while being shielded from its negative aspects by adopting a strategy that is neither very risky nor overly conservative.
In his 2007 book “The Black Swan,” risk analyst and novelist Nassim Nicholas Taleb argues that this notion is incorrect since “middle-of-the-road risks” have no direct connection to the risks at the tails (extremes) of the distribution. Despite what his average body temperature might suggest, a man who has his head in the freezer and his feet in the oven is not okay.
Consider the 60/40 stock/bond portfolio, which is the conventional method of risk management. It resulted in a 6.9% loss over the three U.S. trading sessions that ended on Monday (assuming that the bond portion was invested in long-term Treasurys and the stock portion was invested in the S&P 500 SPX).
Taleb advocated a “barbell” method, which differs from conventional risk-management techniques: “Your strategy is to be as hyperconservative and hyperaggressive as you can be, instead of being mildly aggressive or conservative.” Investing the majority of your portfolio in Treasury bonds and using the interest you receive from these US government securities to purchase S&P 500 call options is one barbell technique.
Indeed, there will still be some short-term volatility in this method. However, as long as you keep the Treasurys until maturity, you won’t lose money with this strategy because you’re only investing the interest you earn. Additionally, you will share in a large portion of the market’s gains, contingent on the options you buy and the performance of the S&P 500 SPX.
Individuals can now use these advanced game plans through exchange-traded fund providers. One that uses a variation of Taleb’s approach is the Amplify BlackSwan Growth & Treasury Core ETF SWAN, which allocates 10% of its investments to S&P call options and 90% to U.S. Treasurys. The index that this ETF is benchmarked to was calculated back to December 2005, despite the fact that it was formed in late 2018. It has generated an annualized return of 6.8% during the backtested period, while the S&P 500 has generated an annualized return of 8.4%.
Stated differently, this black-swan insurance has historically had an annualized “premium” of 1.6 percentage points. You might conclude that this is a reasonable payment in light of the tension and fear of the previous sessions.
Investing the majority of your portfolio in stock index funds and allocating a minor amount to S&P 500 put options is another barbell strategy. The Swan Hedged Equity US Large Cap ETF HEGD is one ETF that follows a variation of this strategy. The issuer of this ETF provides performance data for managed accounts that followed a strategy that was quite similar to the ETF’s (which was introduced in late 2020) approach as far back as 1997. This approach trailed the S&P 500 by 7.5% annually, or 9.1%, from the middle of 1997 to the end of 2024. That translates to an insurance cost of 1.6 annualized percentage points, which is almost the same as the ETF offering from Amplify.
The bottom line? It is impossible to avoid black swans. Furthermore, as they are also unpredictable, insurance against them cannot be based on our ability to predict when one will happen. Answer truthfully: Did you have any clue what would happen over the next three sessions prior to April 3?
Having insurance plans in place through thick and thin is essential for protection from black swans. Homeowners never allow their insurance to expire. Additionally, you shouldn’t get any black-swan insurance.
