Opinion: If you’re worried a ‘black swan’ event could push stocks deeper, here’s how to manage the risk

The stock market pullback following Russia’s invasion of Ukraine certainly looks like a black swan, but it really isn’t.

The term “black swan” describes an unlikely and rare event, and it is often misused when it comes to investing. Not only is it inaccurate to portray recent market weakness as a black swan, it misleads investors about what can be achieved with strategies designed to protect against a true black swan.

Author Nassim Nicholas Taleb introduced the term “black swan” in his 2007 book titled “The Black Swan: The Impact of the Highly Unlikely”. Black swans in the stock market are sudden, ghastly, unpredictable and extremely rare – like a stock market crash. They are not, as Taleb complained in an interview with The New Yorker two years ago“any bad thing that surprises us”.

The current correction in the US stock market – as well as its apparent immediate cause – Russia’s invasion of Ukraine – does not qualify.

This has important investment implications. Taleb and others have definite ideas about how best to protect our portfolios from black swans, and their strategies have failed to protect investors so far this year. Since true black swans are rare, black swan protection strategies will only rarely pay off, albeit dramatically when they do. They will lag the market, or even lose money, almost all the rest of the time – but hopefully with margins small enough not to waste the rare gains.

Investors who pursue black swan hedging strategies without understanding these characteristics will be deeply disappointed. They are therefore likely to abandon the strategies before they offer the protection they are supposed to offer.

Insurance policy

Think of these protection strategies as insurance for your home. Most years you lose the premium you pay to the insurance company, but the insurance policy is very profitable if the worst happens.

In a column last summer, I described two conceptually similar, though quite distinct, ways of insuring against a black swan. One approach is to allocate a small portion of your equity index fund portfolio to long-term out-of-the-money put options. Another is to invest most of your stock portfolio in US Treasuries and, with the balance, buy out-of-the-money call options.

In theory, both approaches should produce similar returns over the very long term. They have certainly so far this year, with both losing almost as much as the market itself. I calculate that the index fund plus put strategy has lost 9.5% so far this year through February 24, like the S&P 500 SPX,
+2.24%.
Meanwhile, the bond-plus-call approach lost 9.6%, judging by the SWAN Amplify BlackSwan Growth & Treasury Core ETF,
+1.12%.

Certainly, you could design a strategy that, instead of insuring against a black swan, protects against smaller losses. But the cost of insurance would be prohibitive; you would lose too much upside potential.

Taleb argues that risk is not something you can simply increase or decrease in order to increase or decrease the expected return. The assumption that risk and reward are linearly related is the basis of many investment theories, including the academic financial asset pricing model. Quoting Nietzsche, the site of the hedge funds Taleb is affiliated with casts a shadow over this cornerstone: “Certain convictions are more dangerous enemies of truths than of lies.

Taleb says intermediate risks are not directly related to extreme risks and rewards. He therefore recommends an approach known as the “barbell” strategy, which he describes as follows: “Your strategy is to be as hyper-conservative and hyper-aggressive as possible, instead of being mildly aggressive or conservative.” The two strategies discussed above are different examples of this barbell approach, although Taleb’s specific strategy is proprietary.

The bottom line? The relationship between risk and reward is complex enough. Don’t make it even more inscrutable by calling every bad thing that surprises us a black swan.

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected]

Continued: Russia’s invasion of Ukraine could send stocks tumbling for weeks before the market finally hits bottom

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Joseph K. Bennett