A black swan event, according to the theory developed by Nassim Taleb in his 2007 book, The Black Swan, is a seemingly improbable or unforeseeable event with dramatic consequences. Despite the statistically insignificant frequency of such events, their massive impact and resulting shock are too real to ignore.
Unfortunately, and equally improbably, we have a few recent examples that show black swan characteristics: COVID-19, the housing-led financial crisis, and 9/11. Wall Street also refers to these events as “tail risks,” disasters that are estimated to have less than half of a percent chance of happening. Odds this low have not prevented Wall Street from selling billions of dollars in black swan/tail risk funds to investors frightened by the recent bear market and anxious to profit from the next disaster.
So, should investors include these black swan/tail risk funds as part of their portfolios? Is this type of “insurance” reasonable? We are reminded of the cliché, “There is no such thing as a free lunch.” Hedging against downside risk sounds attractive, but one must analyze the costs versus the benefits. Portfolio hedging of any type is very expensive, and there is no guarantee the hedge will work as expected. This happened during the Black Monday market crash of 1987, when portfolio “insurance” failed to protect the value of portfolios and, in fact, helped exacerbate the sell-off.
A better, more cost-effective approach for investors may be to concentrate on appropriate asset allocation. If you have a low threshold for volatility, include a higher percentage of short- to intermediate-term bonds. If you have near-term expenses, higher levels of cash are warranted. Haverford clients who maintained a portfolio asset allocation of 70 percent equities and 30 percent fixed income from January 1, 2008, through December 31, 2009, saw their accounts decline by only 6 percent, compared with a decline of 20 percent in the S&P 500 over the same time frame. Active rebalancing can also add to the risk-adjusted returns of a properly allocated portfolio, provided you have the discipline to add to equities during a market sell-off, and, conversely, add to fixed income during an equity bull market.
More than ever, we are subjected to one “crisis” followed by another, magnified by the 24-hour media cycle that realizes fear generates ratings. Investors need to understand that black swan events are extraordinarily rare occurrences that are virtually impossible to predict, and therefore difficult to hedge against in a cost-effective way. Proper asset allocation combined with disciplined rebalancing should provide investors more economical risk-adjusted returns in any environment.
