In June of this year I had the pleasure of attending an investment conference, where such illustrious speakers as former President George W. Bush, former British Prime Minister Gordon Brown, and Bill Bellichick, Head Coach of the New England Patriots, shared their worldviews. Financial professionals from across the industry also shared their views and ideas, and one session focused on the importance of helping clients to understand “left tail risk” and managing “the left tail.” You may have heard of this term, which refers to the risk of extremely unlikely but catastrophic events occurring (as popularized in Nassim Nicholas Taleb’s book The Black Swan), but very few investors understand how tail risk applies to managing their portfolio.
Examples of such extreme catastrophic events, often called “left tail events,” include the 2008 subprime credit financial crisis, the tech wreck of 2001, and Black Monday in 1987. These broadly damaging events affected countless investors, and show the limits of standard portfolio management techniques. How? Well, when seeking to manage exposure to risk, we usually talk about diversification, or spreading your portfolio across several asset classes. You know that you need to have a mix of equity and fixed income, domestic and international, large company shares and small. However, in the kind of extreme events that produce broad market crashes, these standard asset classes can end up declining together. We saw this in 2008, when it seemed that there was no place to hide as the market dropped.
The real possibility of market crashes must be addressed by constructing a portfolio which is designed to minimize these types of risks. I believe one of the best and most accessible methods of reducing tail risk is to diversify into alternative investments. Alternative investments include asset classes and strategies that are less correlated with the broad market than standard investments, and should move quite independently of the market. This lower correlation hedges against the possibility that all your assets lose value at once, as your alternative holdings may rise or stay flat while your stocks and bonds fall. Commonly used alternative investments include commodities, futures, and floating rate fixed income and strategies such as long/short or hedged equity allocations. You can access these strategies through mutual funds, which provide a high level of liquidity and could also be a good strategy for adding downside protection to your retirement accounts. In this case, you may want to consider rolling over your 401(k) from a prior employer into an IRA, as 401(k) accounts typically don’t have access to these strategies.
Of course, it is important to remember that alternative investments can also lose value. However, because they are generally uncorrelated with the broad market, they provide a hedge against losses if the market goes into a tailspin. It is also important to keep in mind that reducing losses on the downside is associated with potentially dragging performance on the upside precisely because alternative investments do not move in lockstep with the market. As such, keep your overall goals in mind and remember to set an appropriate benchmark: A well-diversified portfolio should never match the performance of the S&P 500 Index! It’s commonly used because it’s easy, but the S&P 500 is a portfolio of 500 large American equities. In order to really gauge the performance of your portfolio, you need to look at the big picture, including any fixed income, international, and alternative holdings.
I believe a well constructed portfolio adds more predictability and stability, provides some downside protection while mitigating risk. However, as with any strategy, you should talk with your advisor about your specific needs before incorporating alternative investments into your portfolio. While diversification among asset classes is a widely known piece of investing wisdom, alternative investments should be added carefully.
Read my article about Managing the Downside in your portfolio, which provides more information about tackling risk management and reducing the volatility of your portfolio.
For information about managing your IRA or a 401(k) rollover, download my free eBook, “10 Tips You Need to Know About Your IRA Rollover.” This short book is packed with critical information that will help you make the right decisions about your retirement savings.
Written by Bradford Pine
Bradford Pine Wealth Group – New York City Financial Advisors
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