The question of whether or not individuals need this sort of thing or what the realistic objective should be makes for good contemplation. This is the sort of thing where there is no single correct answer that can work for everyone.
I believe the concept of trying to avoid the full brunt of down a lot is related to hedging tail risk. When framed as hedging tail risk is seems as though there is an attempt to try to assess what the risk might be (my perception, there are many correct answers). It probably makes more sense to think in terms of simply protecting against some extreme event that you accept you cannot predict.
There are all sorts of different types of assets or segments that do provide some measure of protection many of which I've written about before. Obviously an inverse index fund will help when a disruption causes the stock market to go down a lot and obviously they are accessible.
As you can see from the table that Felix provided, managed commodity futures offer a port in the storm and there are a lot of funds out there that target this space. We've had good luck with the Rydex Managed Futures Fund (RYMFX) but to the extent any of this interests you, you should do your own work.A little more broadly speaking there are a lot of absolute return mutual funds out there, some did well in 2008 and some did not and there is no way to be certain that a fund that did do well in 2008 will do well the next time.
Commodities generally did not hold up but gold did. It is not perfect and it did not go straight up and obviously cannot be counted upon to do so but take a look at a chart of the SPDR Gold Trust (GLD) which we own for clients. Gold attracts buying interest in times of fear and this is true of quite few different types of fear; this is the reason I own it.
Despite all of the apparent problems in the US with debt levels, unemployment and all the rest the US dollar and US treasuries continue to attract frightened money. Treasuries could continue to do well and do well in the next tail event but that does not change the fact that buying treasuries here is buying high.
I do think that certain equity exposures can offer some protection but it takes some legwork and the proper expectations. The context of many of my blog posts in this regard has been that foreign markets will still go down in the event of some big disruption but that some can go down less and recover sooner and this is exactly what happened with some countries. I've talked about these places has having cyclical events compared to the US and Europe's possible structural or secular events.
Some of the quirky stocks I've mentioned over the years ended up delivering this sort of low correlation, or tail risk protection but of course others did not. This is another area where everyone should really do their own work but these types of names are out there, if I can find a couple you can too and couple is all you need.
The last point here is one of proportion. This boils down to tolerances. I believe down a little goes with the territory but you may not or maybe my idea of a little is different than your idea of a little. There is a reference in the article linked above about one tail risk strategy spending 6.7% of the account to protect it against meaningful disruption. As I understood it, this would provide a lot of protection below a certain point.
Anyone wanting a lot of protection could buy a lot of puts. My preference is simple avoidance, it is cheaper. Inverse funds don't expire and it doesn't take much exposure in one to neutralize some of the downsize. Add in selling a couple of things and prudent exposure to some of the things mentioned above and I think you can protect against down a lot regardless of whether you hedged tail risk.
9 comments:
Thoughtful post, Roger, thanks.
Seems like this adds up to a convincing argument for the Permanent Portfolio, though I personally prefer more diversification.
implied in this, i think, is pulling together disparate concepts to create your solution--that is if a solution here is even suitable. For one person this might be suitable and for another person, not.
The problem is, tail risk is an extreme and rare event, so there is no reliable way to institutionalize protection against it.
A 20-year setback in any market is understandable, and can be insured against. A 50-year setback, though, would take down any insurer; that's when people get into owning physical gold, to bypass any counterparties. But if you can imagine that, you can also imagine events even more extreme, that would take down any institution that could trade gold--then you join the stockpile-canned-food-and-ammunition fringe.
Once you start trying to protect against extremes, it's hard to know when to stop. And it all cuts into actually living the life we have.
cuts into actually living the life we have
is that what you actually mean or or are you separating our investing lives from actual lives?
related article in the WSJ today on the Collar Fund which i mentioned once or twice here and also profiled for the Street.com
Not to get too political but:
How do you hedge the restraint of free markets risk? To me this is more worrisome than the enevitable ups and downs of economic cycles. The over reaching of the federal government into our financial lives with burdensome rules and regulations with the "income redistribution" crowd running the show is troubling to me. Those of you running your own businesses know exactly what I'm talking about. The fear out there is real. I'm a mostly taxable investor, and there doesn't look like there is going to be much left over for me for taking risks. And by not taking risks, I cannot even keep up with inflation.
Without the rule of law that support free markets, what chance do the well thought out plans really have?
you're concerned with the federal govt impeding or interfering with our capital markets?
wouldn't the answer be to invest in other countries where you perceive this threat does not realistically exist?
Roger beat me to it, but I would also add that precious metals would hedge against political uncertainty.
My take on this is the U.S. economy has become dominated by large multinational corps (whose interests do not necessarily coincide with America's) leaving it open to heavier regulation whenever the party in power feels pressured to do so. Unfortunately this is hard to reverse...
Mark from L-Ville
To answer your first question, yes.
With regard to your secend question, I dunno. Perception does not always equal reality as you well know. I recommend "The Prize" by Daniel Yergin. It is basically a history of the petroleum industry, both international and domestic. The book is rife with examples of nationalization and intervention in private enterpise with no recourse. Venezueala is a recent example.
That's not to say I don't believe in internatinal diversiication however.
I can see how my previous comment might be seen as having come from the "fringe", but I can assure you that many of my colleagues are hoarding capital and deferring business plans due to uncertainty over federal rules and laws. Your industry may be different.
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