Scared of the Downside: Implications of the Fat Tail Risk (Part 3 of 3)

By David Geller, Aradhana Kejriwal   |   September 22, 2012

As bad as the 2008-2009 Financial Crisis was, it wasn’t the first or the worst crisis to rock the markets. Throughout our history, there have been a number of extreme, and often severe, market events.

In the financial world, fat tail risk refers to unpredictable, rare and extreme market swings (generally down). Investors may recall the most recent such event, when the S&P 500 fell 6.6% on August 8, 2011. Another example occurred on Black Monday, October 19, 1987, when the S&P 500 fell 20% in a single day. Using daily average returns of 0.65% of the S&P 500 in the 50 years before that, statisticians would say that this event (fall of 20% in 1 day) was 25 standard deviations away from that average. Simply put, the likelihood of it happening was rare.

In this article, we discuss the history of tail risk events, review five investment considerations GV follows to mitigate such risks, and offer an options strategy that might work like insurance, not as a cure, albeit at a cost. Of course, should you want to purchase such insurance, the time to do so is before the market drops; if history is any guide, investing in this options strategy after a tail risk event likely will not have a positive effect on your portfolio. Because the markets historically have recovered significantly in the year following market drops of five percent or more, we believe that getting out of equities after an extreme drop is not advisable.

A Brief History of Tail Risk: A More Frequent Problem for Investors?

A growing number of experts now believe that these extreme events occur more frequently than previously believed. Ignoring Black Monday, if market returns followed a typical bell curve, statistical analysis would suggest the S&P 500 would move up or down by 3.5% or more in one day, only once every 10,000 years. Yet since 1950, we have experienced 118 such occurrences – nearly half of them in the past two years (Forbes). These anomalous events give fat tail risk its name as the ends of these bell curves are “fatter” than a typical bell curve.

Why does investing have fat tail risks? While there’s no consensus as to why these occur more frequently, rational explanations include:

  • An increase in the number of risky business undertakings
  • The unpredictability of human investment behavior
  • The growing number of engineered financial products and programs in today’s markets.

Certainly, human trading behavior can be irrational over the short-term, especially following market and economic crises.

Is there any solace for investors?

Markets have recovered from short-term drops. Since 1950, the S&P 500 has dropped at least 5% in a single day 24 times. In the year immediately following those approximate 5% tumbles, the S&P 500 rebounded an average of +18.8%, and in the year following the 8/8/11 drop of 6.6%, the S&P 500 gained 16.91% (Source: BTN Research and Google Finance; returns do not include reinvested dividends).

Some Investment Considerations for Tail Risk Protection

While we believe the risks posed are temporary, driven by emotions and market engineering, we acknowledge that they do occur and that they can and have had a significant short-term impact on your portfolio. Here are five key investment considerations that we employ in constructing our clients portfolios to mitigate risk:

  1. We consider the potential impact of extreme market events on our clients, as they do appear to occur more frequently than historical statistics would forecast. We incorporate today’s increased volatility into our financial decision-making. We acknowledge the current higher volatility in asset classes and the increased correlation between them when constructing our client portfolios and when designing their financial plans.
  2. We seek to provide sufficient liquidity in portfolios’ to meet investors’ short-term needs. Should you be forced to sell during market panics, you could suffer some potentially large losses. The key to avoiding costly forced sales is to anticipate your short-term cash needs and develop a solid plan to meet them.
  3. We consider the complexity of investment products. The structure of the market as a source of risk came to the forefront in 2008 when complex derivative products (e.g., credit default swaps) helped ignite the Financial Crisis. While Wall Street seems willing and eager to construct any number of novel products to meet investor demand for tail risk protection, we are cautious of the dangers of over-engineering strategies and remain wary of hidden complexities, expenses and potential design flaws inherent in any complex derivative product.
  4. We help manage investor emotions. While tail risk events are scary, the primary reason investors get hurt by them is that they panic and sell with the herd, selling when it is time to hold on or buy. Rather than being surprised by these extreme events, we embrace the fact that such events can occur and we developed a systematic process designed to help investors manage their emotions and reduce stress so they can avoid the herd mentality to sell.
  5. We evaluate popular tools used to offset tail risk. Some of the tools typical investors choose include:
    • Timing the Market by moving to Cash: While cashing out will protect you from downside risk, remember that this strategy has significant costs of its own. Without exposure to equities, investors bear the lost opportunity cost; sitting on the sidelines could cause investors to suffer negative returns after inflation and reduce the purchasing power of their money over time. Studies show that missing the best 30, 40 or 50 days in the market over a 20 year period, results in negative returns while staying invested for all the 5,042 trading days’ results in a high single digit return. (Source: Morningstar, US Large Cap Stocks, 1992-2011)
    • Shorting the market: While this strategy provides some protection, it also might harm investors’ portfolio should the market rise instead of fall. Moreover, there are real costs to this increased leverage.
    • Investing in Volatility Products: Volatility strategies are in vogue these days. These sometimes complex and costly strategies promise negative correlation to the market (simply said, they are designed to move in direct opposition to the market). While these strategies might perform as promised, they also have the potential to cause losses in the portfolio if the market abruptly changes direction.

One obvious observation is that none of the above strategies is a magic bullet, and each comes at a cost (premium) just like insuring your house or car does. Rather than chasing the investment fad du jour, we evaluate each strategy as we construct client portfolios and employ those which we believe meet our client’s risk and return profile.

Our Options Strategy

In response to investor concerns over fat tail risk events, we have developed an options-based strategy designed to offer investors an alternative to moving out of equities entirely or enduring what they perceive as another gut-wrenching market decline. Based on fundamental investment principles, our options strategy is designed to offer investors limited protection against some large, short-term market losses. While we can inform and advise you, only you can decide whether the potential benefits of this or any strategy outweigh the costs.

Conclusions

Even when confronted with prevailing market conditions and the challenges associated with fat tail risks, we continue to believe that a long-term fundamental approach and a carefully crafted process-based asset allocation strategy offers our clients the highest probability of meeting their long-term goals. Investor interest in tail risk protection appears to be motivated by the fear of market downfalls and the recent rise in the volatility of the markets. As noted in #5 above, not all tail risk protection products produce the cure investors are after, and in fact, under certain circumstances, some strategies might actually increase the risk to your portfolio. Investors should carefully consider the real costs associated with any insurance strategy.

GV takes an active approach to investment management.  We continually scan the investment horizon for potential threats to  portfolios as well as opportunities to enhance portfolio returns. Should you wish to learn more about our options strategy, please contact us here.

David Geller

About the Author

CEO David Geller co-founded the firm in 1991 and led the creation of Behavioral Wealth Management. Recognized on numerous prestigious "top financial advisor" lists, David is an in-demand speaker for professional groups and JOYN workshops. His writings have appeared in The New York Times, The Wall Street Journal and The Huffington Post.

Read More By David Geller >>

Aradhana Kejriwal

About the Author

Aradhana Kejriwal, CFA®, is JOYN's Chief Investment Officer and co-chairs the Investment Committee, which formulates and implements the firm's investment philosophy, strategies, processes and procedures. With 19 years of investment experience, she's a popular industry writer and speaker.

Read More By Aradhana Kejriwal >>

Join Us

When wealth advisors look and sound the same, how do you choose? A coin flip? Pick your neighbor? Why leave such an important decision to chance? Instead, join us at an upcoming workshop. Hear recent research, discover new insights, and experience JOYN’s transparency and expertise firsthand.

Get In Touch