The Wall Street Journal advises tail risk hedging. But should you?

Is tail risk hedging really the best way to protect against a "Black Swan" event?

By , Guest blogger

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    Black swans are rare in nature, which is why "black swan" has come to mean an event that is unexpected, remarkable - and often devastating.
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Here a swan, there a swan, everywhere a Black Swan.

The Wall Street Journal lets us in on the hottest new trend for individual investors - making tail risk hedging a part of their portfolios. The Black Swan event of 2007-2009 has shown people that no amount of diversification of sectors or asset classes will matter in a crisis. During a Black Swan event that arrives and quickly shreds through everyone's models and assumptions, correlation goes to a non-ratio of 1, bonds=stocks=commodities=real estate. When they raid the whorehouse, even the piano player gets hit - remember the money market funds that broke the buck? Now that's some serious Swan-age.

Investors of every size and shape have learned that lesson well and are now seeking out products and methods to help them profit from the next Black Swan. And the Wall Street assembly line is all too happy to provide those products. Oh boy...

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Diversification "works most of the time, but when it doesn't work, those times really kill you," says John Liu, who heads up Citi Portfolio Solutions, a newly formed unit at Citigroup Inc. dedicated to developing and managing tail-risk hedging strategies for institutional investors...

Risk management by the Godfather of Modern Risk Generation, Citigroup. Terrific, send me the forms.

And Wall Street is always happy to cater to investors' bullish or bearish whims, so long as it can charge fees. "Whenever an investment company tells you that they've come up with a product that can protect you from black swans, you should hold onto your wallet," says William Bernstein of Efficient Frontier Advisors.

More like hide your wallet.

I don't mean to be overly cynical, but the difficulty of building a portfolio that remains breakeven in flat markets or even up markets and then rises dramatically during a Black Swan crash cannot be over-emphasized. And it may not make sense for most investors to even attempt this given what their goals are.

Building a Black Swan-profiting account and then maintaining it by constantly replacing long-dated naked puts that have expired is hard work and can wear out your capital the longer you're waiting for the next crash.

One doesn't put granite counter tops and Viking stainless steel appliances into their fallout shelter, they put them in their house. In this way, an everyday portfolio should be more focused on managing risk than on benefiting from risk.

Source:

Preparing for the Next Black Swan (WSJ)

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