Why we can’t time tail risk.
No one likes uncertainty. It interferes with our basic needs to plan and think ahead. Not knowing what is going to happen can cause such stress in people that some experience muscle pains, others have blurred vision, and many even have heart attacks. A friend of mine once gave me good advice to deal with things I cannot control. He said, you cannot prevent bad things from happening to you. A pandemic can strike at any time, as can a car when we are crossing a road. You can actively try to avoid risk by staying safely locked away in your home, but we all know how that is turning out. We have to live, we have to take risk, and the only thing we can do is deal with whatever happens to us in the best way possible.
So, is there anything we can do to protect our investment portfolios against so called “tail risk”, or the chance that everything may go wrong? There is insurance and thanks to the $750 trillion in outstanding financial derivatives contracts, we can protect our portfolio against anything. However, beware the pitfalls of this endeavour, as once you insure yourself against all risk, then you also won’t make any money, thanks to the no free lunch theory. Hence, we have to choose which risks we would seek to insure, but this is where it gets complicated, and also expensive if we get it wrong. Every crash is different, otherwise there wouldn’t be a crash, which makes buying insurance on something we don’t know somewhat difficult. To say nothing of trying to time when said tail risk may occur. Remember, insurance only works when you pay the premiums, and it could be years before anything actually happens.
Generally speaking, the point of insuring is to get as much bang for your buck. In other words, pay the smallest premium but get the highest cover. A lot of that has to do with when you buy your protection. Financial derivatives are priced in volatility, and at the moment, it would cost you twice as much to insure your portfolio than it would have last year, pre-COVID. Makes sense I suppose, but not necessarily easier as most of us tend to lock the barn doors after the horses have left. Be that as it may, buying insurance when the markets are less volatile is a good thing to bear in mind.
Which brings us back to this matter of uncertainty. The thing is, if I now have to choose those things that I am most apprehensive about, knowing that I am probably wrong, because the future is unpredictable, then that is precisely what I would be worrying about. On top of that, insurance costs a lot of money, so there is even more reason to fret about whether or not the horrible event that I am anxious about may actually come to fruition, because you know, I might be insured against that. The easy solution is: if you are concerned about the risk in your portfolio, then take less risk. Saves a lot of time, money and worry, ironically.