Experienced investors know that even with extreme results – even if it rarely occurs. But should you secure your portfolio against it?
• Investors are often too careless
• Black swans should also be taken into account
• Different options for tailproof protection
Many investors tend to underestimate the likelihood of negative events. But there are good reasons against such “black swans” as they are called. This applies in particular to short -term market participants who need liquidity, as well as to pensioners and generally for risk -new investors.
The tail risk
Such extreme market movements that rarely occur, but have significant effects when it occurs, is called tail risk. These “tail events” lie at the outer ends of a return distribution and often collapse with financial crises, violent market slumps or systemic shocks.
According to “Optimized Portfolio”, it was empirically demonstrated that asset returns actually tend to end fat – i.e. a higher probability of a rare event – than would predict a perfect bell curve. In the middle of the bell curve is the average expected return of an investment, while at both ends of the distribution the rare but extreme results are located. An ideal portfolio strives to shorten the left end area to reduce extreme losses, while the right end area remains unchanged in order not to slow down above -average profits.
Tail-risk insurance
There are different strategies to secure yourself against the extreme risk. The simplest method is broad diversification, which means a global investment over various industries in a stock system. Other asset classes, such as government bonds, which on average identify a moderate negative correlation into shares or gold, which is usually uncorrelated with both stocks and bonds.
Now, however, it can happen in times of strong market riots that even these assets correlate positively and therefore do not offer effective protection. For this reason, in some cases it can make sense to add assets that are referred to as “negative carrry”: these are assets for which the holding costs are higher than their expected return.
For example, a so-called protective put strategy would be possible. In addition to the underlying, a sales option is added. Such a put option gives the buyer the right, but not the obligation to sell the underlying asset at a fixed price, the so-called strike price, within a certain period of time. A protective put acts like an insurance policy by providing downward protection in the event that the price of the financial value falls – any losses are limited. A fee that is called Premium is due for this.
Editor finance.net