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FA Center: If you’re worried about a ‘black swan’ event sinking stocks deeper, here’s how to manage the risk

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The stock market’s downturn over Russia’s invasion of Ukraine sure looks like a black swan event, but it really isn’t.

The term “black swan” describes an unlikely, rare occurrence, and it’s often misused when it comes to investing. Not only is it inaccurate to describe recent market weakness as a black swan, doing so misleads investors about what is possible to achieve with strategies designed to protect against a genuine black swan.

Author Nassim Nicholas Taleb introduced the term “black swan” in his 2007 book entitled “The Black Swan: The Impact of the Highly Improbable.” Black swans in the stock market are sudden, awful, unpredictable and extremely rare — such as a market crash. They are not, as Taleb complained in an interview with The New Yorker two years ago, “any bad thing that surprises us.”

The current U.S. stock market correction — along with its apparent proximate cause — Russia’s invasion of Ukraine — does not qualify.

This has important investment implications. Taleb and others have specific ideas for how best to protect our portfolios from black swans, and their strategies have not protected investors so far this year. Given that true black swans are rare, black-swan protection strategies will pay off only rarely — though spectacularly when they do. They will lag the market, or even lose money, almost all of the rest of the time — though with luck by small enough margins so as not to fritter away the rare payoffs.

Investors who pursue black-swan protection strategies without understanding these features will be sorely disappointed. So they’re likely to give up on the strategies before they provide the protection they are designed to give.

Insurance policy

Think of these protection strategies as insurance on your house. Most years you lose the premium you pay the insurance company, but the insurance policy pays off in a really big way if the worst happens.

In a column last summer I outlined two conceptually similar, though quite distinct, ways of insuring against a black swan. One approach is to allocate a small portion of your equity index-fund portfolio to out of the money, long-dated put options. Another is to invest the bulk of your equity portfolio in U.S. Treasurys, and with the balance purchase out-of-the-money call options.

In theory, both approaches should produce similar returns over the very long term. They certainly have so far this year, with both losing almost as much as the market itself. I calculate that the index fund plus puts strategy has lost 9.5% so far this year through Feb. 24, the same as the S&P 500
SPX,
+2.24%
.
Meanwhile, the bonds-plus-calls approach has lost 9.6%, as judged by the Amplify BlackSwan Growth & Treasury Core ETF
SWAN,
+1.12%
.

Granted, you could design a strategy that instead of insuring against a black swan, protects against smaller losses. But the cost of the insurance would be prohibitive; you’d forfeit too much upside potential.

Taleb argues that risk is not something you can simply dial up or down in order to increase or decrease expected return. The assumption that risk and reward are related in this linear way is the foundation of much investment theory, including the academics’ Capital Asset Pricing Model. Quoting Nietzsche, the website of the hedge funds with which Taleb is affiliated casts a shadow on this cornerstone: “Some convictions are more dangerous enemies of truths than lies.”

Taleb says that middle-of-the-road risks are not related in a straightforward way to risks and rewards at the extremes. He therefore recommends an approach known as a “barbell” strategy, which he describes this way: “Your strategy is to be as hyper-conservative and hyper-aggressive as you can be, instead of being mildly aggressive or conservative.” The two strategies discussed above are different examples of this barbell approach, though Taleb’s specific strategy is proprietary.

The bottom line? The relationship between risk and reward is already complex enough. Don’t make it even more inscrutable by calling every bad thing that surprises us a black swan.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

More: Russia’s invasion of Ukraine could keep stocks sliding for weeks before the market finally hits bottom

Also read: Ukraine war, surging inflation and wild price swings: Here’s how some see the state of stock market as Biden readies crucial State of the Union.

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