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The Imperative of Tail Risk Hedging

Anyone who proposes investment schemes to investors without proper tail risk hedging is probably too naive about risk.

“The Imperative of Tail Risk Hedging.” These are the words of N. N. Taleb. It is recommended to watch the video (link is provided at the end of this article.)

One must distinguish between traders and the investors who are looking for retirement income. Most traders, at least those that survive ruin, understand risk and usually have small exposure per position. Some manage to grow the account due to skill or luck but most trade because they like the action; they do not care if they end up flat or losers after a few years. Trading keeps them focused on markets and it is exciting.

Investing is a different animal. But many in the finance industry have borrowed schemes invented by traders and have applied them to investing. Trend-following and momentum are risky trading schemes that some have elevated to investing methods.  Why? Because they do not know better and they do not understand risk. Especially risky is the passive investing strategy. Yet, it is promoted as the safest investment style. Why? Because those that promote it do not know better or, to be exact, they know nothing about risk.

In this blog we have analyzed the risks of trend-following, momentum and passive investing strategies in several articles. There is little to be gained by repeating the obvious: any investments in the markets without some kind of tail risk protection are subject to tail risk: 1987 crash, dot com crash, financial crises, 2011 correction, flash crash, etc.

“But if you look at longer-term charts market prices always go up” argues the naive. Yes, markets go up in the longer-term but not the same portfolios go up in value. Here are some real-life examples.

Story of J. 

One day during the Russian Ruble crises in 1998 I received a call from a friend. I was a trader and he was an investor with an investment bank. He had invested about $5 million dollars in international equities including US large caps. He asked me if I could go to his office as fast as I could. I had closed a few positions and at that time I was driving to meet some friends for launch. I drove fast to his office. I found him with a nurse on an oxygen mask. I learnt that his banker called and his account was down about 50%. He was desperate asking me what to do. What about if the market continues to go down? What about if the loss grew to 70%, how easy it would be to recover and how long it would take?

I had no answers. I told him that life is more important than money and he could make it again working hard in his restaurant. I thought he was going to die. His banker who followed some trend-following models was in worse panic and he closed the positions and the loss became realized.  At least my friend kept about 2.5 million dollars because he could have lost everything in the dot com crash that followed. He survived.

Story of A.

A. was a doctor. He thought he understood markets and always called his broker with suggestion about managing a portfolio of about $500K of money he had earned working hard most of his life.

One day during 2000 he called me and asked me what I thought about some high tech stocks because he heard on financial TV that prices will go up. I told him to get out of the stock market. He told me that I was crazy; everyone was making tons of money. Next thing he knew his portfolio was losing about 70%. He took the loss and tried hard to forget it. Now, when the naive look at the charts, they can only see a long-term uptrend. The losses of people like A. are not shown on the charts. “If you have bought Amazon at IPO you would have made 45000%” is the single tweet that infuriated me most in the last few years. This was my response.  I mean, the stock had a 90% drawdown in 2001.

Story of M.

This is a sad story. M., a close friend, worked all his life in retail as a store owner and saved about $300K for retirement. He hoped to grow  it to $1 million and invested in the markets. His investment banker called him during 2008 and said that they lost everything because they had invested with a fund that used leverage. But the S&P 500 is now way higher than the 2008 top thanks to central banks. M. would say to anyone who shows a longer-term chart as evidence that markets go up that he is an idiot. Markets go up, portfolios may not go up.

The above three stories have something in common: no tail risk hedging. There is also another common factor: trading schemes masqueraded as investment strategies.  Tail risk hedging is hard. N.N. Taleb said: “If you know how to do it.” It is also expensive and returns expectation must be lowered in its presence.

I am amused by all those finance people that have been elevated to experts while proposing naive schemes that lack any respect for tail risk. Investing is not trading but most investing is indistinguishable from trading but at higher risk. Most savvy traders risk 2% of their capital on each trade. Most investors risk 20% or even more without even realizing it. We live in a world where many things can go wrong at any time and markets can crash.  The argument that in the longer-term markets go up is silly because fear and panic dominate market crashes: most get out at a loss.

As N. N. Taleb said: “Engage in financial markets only if you have tail protection”.

I know this article will not earn me any credits in the finance industry as would for example a naive portfolio of five ETFs configured with plenty of hindsight. But I do not care. I am a trader and everything I do is related to trading. I am surprised when I see investing schemes indistinguishable from trading schemes regardless of the timeframe or holding period.

Here is the link to the N. N. Taleb tweet and video.

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