Tail Risk Revisited
The risk in financial markets has increased, by measure of the rather large and sudden price swings we have had since the beginning of February. As a result, we are receiving a lot of requests for strategies that could hedge against tail risk or, as we define it, the risk of everything going wrong. So, at the risk of repeating ourselves, here is our view on this very topical matter. (And please do refer to our previous blog What is Tail Risk? Can You Hedge It?)
We have already covered buying insurance, e.g. if you want to hedge your equities position, then you could buy put options to guard against down moves. The cost of doing so is somewhere between 2-4% per year, depending on how much protection you want. That means that if you have no crash for ten years, you could be spending between 25-50% on premiums that you didn’t need. Not good, no free lunch and hence you just don’t do it. And remember, it’s very difficult to know when a crash will come, because they are by definition always different, otherwise there wouldn’t be a crash.
But for the most telling example of why you can’t hedge tail risk, we again turn to real life and point our eyes at the recent events in Salisbury. Not wanting to get into any political or moral debate, but rather thinking about the restaurant owner, Zizzi, your nice, friendly, local Italian. Last we saw, there were 180 soldiers combing the area for evidence. The business was very much closed, until further notice and maybe forever.
Do you think the owners could have hedged that tail risk? Does Lloyds Insurance Group have a policy to protect local restaurant owners against the risk of Russian spies being poisoned at their restaurant? Maybe they do, and it will be right next to the policy whereby you can protect yourself against pigs falling out of the sky. The thing is, you just can’t protect yourself against any eventuality, particularly the ones with such low probabilities of actually happening. Russian spies? Come on.
If you want to hedge tail risk, reduce your position sizes and spread your investments across a variety of strategies that will behave differently. That way, some part of your portfolio will always work and you could also benefit from being able to buy assets at very attractive discounts when a crash does happen. Think of a crash like a 'blue light special' at your local shop, where everything you always wanted is all of a sudden 50% off. Happy crashing!