How Can You Best Hedge Against Tail-Risk?

Tail risk is a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution. Tail risks include events that have a small probability of occurring, and occur at both ends of a normal distribution curve.

Investopedia

Tail-risk:

Nassim Nicholas Taleb has influenced my thinking and mentality tremendously, and he is by many seen as the “father” of black swans and tail-risk (for right or wrong). Tail-risk is totally random and unpredictable and can’t be managed (Taleb says the Covid-19 is not a black swan, it was highly predicted). You can only prepare for it.

How can you hedge a portfolio of stocks against tail-risk?

The easiest and most obvious way is to buy put options which are “out of money” on a broad market index, for example the S&P 500. Out of money means the options are unlikely to get exercised, unless the market drops a lot. If you for example buy put options 5% out of the money on a rolling basis, you stand to gain a windfall if the market drops. The downside is that you have to roll the options over many times. Thus, it comes at a cost.

Meb Faber and tail-risk:

Luckily, Meb Faber has already done the research on the potential cost of “insuring” your portfolio. In October 2019 I came across this article by Mr. Faber, which I strongly recommend.

Faber looked into several ways to “neutralize” bear markets: by using bonds, foreign stocks, commodities, REITs, gold and tail-risk:

The performance of different asset classes during bear markets. Source: Meb Faber, Cambria Asset Management.

For the periods evaluated above, the tail-risk strategy provided the best returns, hands-down. The tail-risk strategy is simply out of the money puts on S&P 500. But the strategy comes at a cost, as Faber concludes:

But remember, this strategy comes at a cost. You’re paying for the protection. That means investing in a tail risk strategy has some similarities to purchasing insurance. And that’s going to affect overall portfolio returns for those of us who aren’t perfect market-timers…..In the same manner, if you are able to avoid a car crash for a year, then your auto-insurance premium can be viewed as having gone down the drain (but we nonetheless renew our auto-insurance each year)…..So, the big question for non-market-timers is “do the strong returns in bear markets balance out the poor returns in rising markets?” Does the insurance premium cover the cost of insurance?

How much of your returns do you need to sacrifice to get tail-risk insurance? Meb Faber went on to quantify the lowered returns:
The return drops, as expected, when a hedge against tail-risk is implemented. Source: Meb Faber, Cambria Asset Management.

Pretty much as expected, the overall returns fall significantly. Based on this, I assume most investors will reject such a strategy. However, we know most investors are not infallible and make behavioral mistakes: buying market tops and selling market bottoms. By having put options you offset some of the unrealized losses and this might make it easier to hold onto your positions.

My own experience:

During 2019 I hedged  my portfolio against tail-risk by buying out of the money puts on the ETF SPY (S&P 500), much like the tail-risk strategy described by Meb Faber. I gave up in October 2019, because the pain of seeing the options expire worthless is too high to bear. In practice, this strategy slowly bleeds you for funds until you hit the rare big pay day. I believe very few investors can tolerate such an ongoing pain. Unfortunately for me, just some months after I stopped, the Covid-19 sent the index into a steep fall.

(Think about this: If you make 500 000 in year one and nothing in the following nine, you will most likely be a lot unhappier compared to receiving 50 000 evenly in all ten years. Behavioral experiments suggest our happiness depends far more on the number of positive feelings than on the amount when they hit. This means any payment is much more important than the size of it. In order to have a pleasant life most people should thus spread these payments evenly. (Even worse is if you make 500 000 in year one and give back 400 000 over the next nine years. It most likely feels better to receive nothing because you have nine miserable years.))

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