Create your own tail risk insurance using derivatives, part 1
How to position for massive payoffs in black swan events
Perhaps you are convinced of the need to ‘insure’ your portfolio. You know that unforeseen events happen which have the capacity to cause massive market movements. For more on this you could read The Black Swan, or The Origins of Financial Crises.
The question is, what should you do?
It’s likely that if you are a member of The Antifragile Company you will be convinced of the wisdom of barbell approaches to both life and investing. That is, being hyper-conservative and hyper-aggressive at the same time. It’s a sad irony that much ‘medium risk’ investment advice is actually simultaneously just as risky as ‘high risk’, yet without any of the stability of ‘super low risk’ investment vehicles. This is because of the exposure to negative black swan events.
So, if we want to construct a barbell, we can answer the hyper-conservative side easily: gilts, treasuries, and cash. We put 85-90% of our portfolio here. The biggest challenge here is really holding our nerve with a portfolio that, most of the time, looks…pretty boring.
What goes on the hyper-aggressive side?
The answer can’t simply be investments which don’t move with the stock indices, like gold or cryptocurrency, or even venture capital/start up investments. For a start, they may well get moved more than we like to think, due to the generalised panic that sets in when a crash happens or a war breaks out. But more significantly, their payoff is not exponential enough. We want a small slice which, in a black swan event, suddenly mushrooms in value.
We’re basically talking about holding options, derivative financial instruments which function exactly like this. In our next article, we’ll consider different ways of positioning for tail events as an individual or retail investor.
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