3 WAYS TO PROTECT YOURSELF AGAINST TAIL RISK

The latest from James Montier of GMO is a must read as always.  He discusses the rise of tail risk protection and the ways in which investors can protect themselves.  He provides three specific forms of protection:

“We are aware of three general groups of tail risk protection from which investors may choose.

1. Cash – This is perhaps the oldest, easiest, and most underrated source of tail risk protection.  If one is worried about systemic illiquidity events or drawdown risks, then what better way to help than keeping some dry powder in the form of cash – the most liquid of all assets.  (There is much more on the joy of cash to come shortly.)

2. Options/contingent claims – Occasionally, the market provides opportunities to protect against tail risk as a by-product of its manic phases.  A prime example was the credit default swaps that were a result of the demand for collateralized debt obligations.  These instruments were priced on the assumption that there would be no nation-wide decline in house prices, and thus offered a great opportunity (even without the benefit of hindsight) for those who were concerned that such an outcome was more plausible than the market thought. Here, one caveat stands out above all others: one must be cautious of the dangers of over-engineering in this area of tail risk protection.  It is too easy to construct an option that pays out under a very specific set of circumstances, and to do so relatively cheaply.  But, of course, such an instrument tautologically only pays off under the realization of those specific events, so the tighter the constraints imposed, the less use the option is likely to be as general tail risk protection.

3. Strategies that are negatively correlated with tail risk – For the specific type of tail risk (illiquidity events) under consideration here, long volatility strategies are often said to be negatively correlated.  The simplest example of such a strategy is just to buy volatility contracts (bearing in mind the roll return will be negative given the upward-sloping term structure of volatility).  In the recent crisis, a dollar neutral long quality/short junk portfolio acted very much like a long volatility strategy (with the added benefit of an expected positive return, in contrast to most insurance options).”

Options and negative correlation are more complex issues, but for the average investor I would not discount the value of cash.  Some might call that an oxymoron – “the value of cash”, but I have been able to generate enormous alpha over the last 5 years in my personal portfolios via the use of cash.   Knowing when to pull your chips off the table is often your greatest talent.  After all, if you can protect the downside the upside takes care of itself.

I view cash as its own asset class.  It is, in my opinion, the ultimate form of protection.  The power of cash lies in one great form of risk mitigation – your emotions.   Nothing will destroy portfolios like your own emotions.   And you can’t make bad decisions when you’re not in the game. Then again, one has to remember that you’ll miss every shot you decide not to take.  Therefore, being in the game is vital and hence, the use of cash should not be abused in excess. Of course, knowing when to deploy cash and get in and out of the game is a another key element of this discussion.  To me, this is largely dependent on the approach you use and how systematic that approach is.   But that’s a discussion for another day.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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