“Chasing Tails”: How To Play Defense Against A “Market Event”

June 7th, 2014
in contributors

Sungarden Investment Research Article of the Week

by Rob Isbitts, Sungarden Investment Research

This is about the time in a market cycle (up for stocks, for several years) that it is prudent to talk not about playing defense, but HOW it is being played. That is, proactively and not reactively.

Follow up:

Perhaps you’ve become familiar with the metaphors “black swan,” “100 year flood” and other references to rare events, such as huge moves in the stock market, or the Milwaukee Bucks winning a basketball game (they lost 67 of 82 games this season). In statistical jargon, events like this are “tails.” Back in statistics class these were the skinny fragments at the end of the graph that represent things that happen infrequently. But they do happen.

One could argue that in the last seven years, we have seen two “tail” events. From October of 2007 through early March of 2009, the S&P 500 Stock Index fell over 50%. Then from that point in March through April, that same index is UP over 175% from the March low. As you now know, a tail event can be a very positive outcome or a very negative one. However, it is vital to understand that they can BOTH be very dangerous to one’s investment psyche, as well as to the portfolio.

So, what lessons do we extract from all of this?

  1. Growing your wealth successfully may require you to take on a different mindset at different times. Putting all of your chips on “buy and hold” investing OR “tactical asset allocation” can leave you very disappointed, and perhaps feeling as if you are always a step behind. Like everything in investing, it’s an educated guess, but we feel that taking a “black-or-white” approach to anything in portfolio management today is a mistake.
  2. Tail risk is something that every financial advisor had better have accounted for in the design of their client portfolios. If you were “kind of conservative” when Iraq invaded Kuwait in 1990, or when the Tech Bubble burst in 2000, or when the financial crisis of 2007-2008 suddenly roiled the markets, was that good enough? Or, do you need a consistently applied mechanism in your investment process that:
    • recognizes the existence of tail events; and
    • allows you to specifically designate a portion of your portfolio toward protecting against tail events?
  3. In 2007-2008 and today, global conflict, market exuberance and staunchly divided leadership may create an environment that makes the risk of tail events in BOTH directions more likely. We believe YES, so we are planning for it in the hedged portfolios we manage.

Don’t end up like the dog that constantly chases its tail. Address tail risk. That is the approach we are taking here at Sungarden.


 









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