By Thomas O. Herrick
Market Strategist
Given the current news flow that holds a number of dramatic events, this is a good time to revisit the subject of portfolio risk management. Whether election implications, Middle East tensions, ongoing war in Ukraine, striking port workers on the East Coast, or recent hurricanes, there are certainly challenges out there. But, from a market perspective, the biggest risks are always the unknown risks. Known risks or concerns are priced into markets at light speed. Unknown risks are completely unpredicted and occur more often than one might imagine. In the rarified world of market strategy, we term these sorts of risks as “tail risk” events, popularly referred to as Black Swan events.
Tail risk refers to the distribution curve of potential market returns and outcomes. The left tail of that distribution curve finds relatively low probability and dramatically negative market returns. Notable examples include the Great Financial Crisis and the COVID-19 pandemic. These events are either impossible or, at a minimum, extremely hard to predict. While relatively low probability, these events have huge portfolio implications, particularly from a sequence of returns perspective. Not properly managed, they can take years to dig out from under.
Among recent risks, we would have judged the East Coast port strike as the most concerning. That strike has now been resolved. Ironically, over the last four decades, the point in history that was most risky in hindsight was 1999, just before the dot-com bubble unwound. It was also the point when optimism was most evident, and no large issues appeared.
The Positive
Here is the good news. Investors need to pay attention to risk, and in today’s market, plenty of tools exist. Twenty-five years ago, the only means at the average investor’s disposal to manage tail risk was a cash equivalent or T-bill allocation. There are now many strategies available to hedge against dramatic drawdowns.
To varying degrees, these strategies will allow investors to remain invested and participate in market upside while limiting downside risk. The world has evolved — hedging strategies are ample and low-cost.
One cannot purchase insurance retroactively after the storm hits. Preparing for uncertainty and not reacting to it isn’t everything. It’s the only thing.
Source: Swan Global Investments
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