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Tales of the unexpected

Unlikely though they seem without the benefit of hindsight, black swan events can and do happen. Hedging against them can therefore be a wise option for investors, says Vassilis Papaioannou, Dolfin’s Chief Investment Officer.

5 March 2018 / Investing

Nassim Nicholas Taleb’s 2007 book The Black Swan discusses extreme, outlier events that can have significant impacts, and the term has entered the investment lexicon. Such events are outside of our normal frame of reference and even though we may come to make sense of them after they have happened, we couldn’t have seen them coming.

Historically, who could have predicted the fall of the Berlin Wall, the 2001 dot-com bubble or 9/11? More recently, we have seen Britain’s vote to leave the European Union and the election of President Trump. Who, in the months running up to them, would have bet on the outcomes that we now rationalise and explain in such simple terms?

Black swan events can impact the largest of financial markets and so negatively affect many investors’ portfolios, as we saw when the value of sterling against the US dollar tumbled on 24 June 2016. Equity markets can take a hit and government bond markets can be jittery. When markets are calm, we tend to forget that they are vulnerable to shocks and are driven by fear and greed. They’re predictable to some extent; we can break down their outlook into components of systematic or unsystematic risk, or beta versus alpha, or predictable and random walk components.

We need to keep in mind the possibility of unforeseeable events.

As investors, we need to keep in mind the possibility of unforeseeable events and consider allocating a small portion of our portfolios to a black swan strategy to offset such tail risk.

Feather your nest

The best time to take action is, as always, when pricing is very competitive, and that’s when markets are benign. It is another of Taleb’s principles that once you lull yourself into a belief that there is such a thing as business as usual, you are opening yourself up to risk. Instead, it is when markets are quiet that there is the opportunity to hedge more cheaply, usually by using the options market.

Remember, an option gives you the opportunity to bet on the outcome of a future event, and if it doesn’t come to pass you need not exercise the option that you’ve bought. If the risk you ‘insured’ against was an unlikely one, the cost of the premium would have likely been minimal and a small price to pay to cover the likelihood of a large potential loss.

Could Italy leave the European Union? Could Trump be forced from office?

So what seismic events should we be guarding against in 2018? It’s easy to dream up a few scenarios – some fanciful, some of which might come true. What if North Korea were to fire a missile at the United States? What if there was a counter-revolution in Iran? Could Italy leave the European Union? Could Trump be forced from office? And what effect would these events have on US Treasury Bonds, on the future of world peace or that of the EU? How might oil prices react?

Mind of the markets

However, just as we can imagine black swan events – though not of course predict them or say when they might occur – so can the financial markets. In some cases, the markets are already pricing in certain major risks, so the cost of investing will reflect them and there is not much point in paying a second premium to take an option. But how can we know if this is the case?

This is where connecting with those who are expert in particular markets comes into play. To many investors, derivative products such as options can seem obscure. Getting the right advice will enable them to determine whether risk coverage is available and, if so, whether it is worthwhile.

Take precautionary measures in times of calm.

So research into markets is a first step to understanding what protection is available against improbable risks coming to pass and negatively impacting your portfolio. Always try to take precautionary measures in times where everything seems to be calm and the outlook is generally upbeat.

For sure, black swan events do happen. There are bound to be events and occurrences that we cannot now predict but which we can at least imagine and protect against. So the thing to do is hold a watching brief and spend a small amount on risk coverage premium as and when market conditions allow you to do so cost-effectively.

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