How To Protect Your Portfolio From Black Swans

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Summary

Nassim Taleb's Incerto contain the blueprint for an improved way of portfolio construction.

Unfortunately, he mostly refrains from giving practical pointers which leaves some room for interpretation.

This is my interpretation of Taleb's work in practice; it is not the final answer.

What we call here a Black Swan (and capitalize it) is an event with the following three attributes.

First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme 'impact'. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

Nassim Taleb - The Black Swan

Much was talked about The Black Swan, which sold over 3 million copies, in the aftermath of the 2009 financial crisis. Today, not much has changed in the asset management industry. That's a shame because it and Taleb's other works making up the Incerto contain the blueprints of a better way to manage assets compared to the modern portfolio theory framework so many of us rely on.

If I simplify the investment universe looks like this going from low return/low risk to high risk/high return:

Taleb's message is to avoid the middle, which gets you to the Barbell Portfolio:

The idea behind it is the left side, consisting of investments, with a low chance of permanent impairment of capital will survive even in case of extreme and unexpected shocks while the right side of very aggressive investments is made up of stuff that's obviously risky but also exposes you to unlimited or very large upside.

Investments that are often touted as predictable, cash generating and stable are avoided and it's these that are most vulnerable to Black Swans. They get wiped out just like the very aggressive investments but they are often priced like they won't be, ex-ante.

How To Protect Your Portfolio From Black Swans

The key lies in the left side of the barbell. It should be made up of investments, assets or contracts, which as a whole lack the ability to lose significant purchasing power no matter what. This isn't easy to achieve and it almost certainly means giving up returns under "business as usual" circumstances.

Unlike a portfolio that's constructed based on the modern portfolio theory there will be a fair bit of redundancy. It will always be tempting to "improve" a barbell portfolio by optimizing its risk/return but that's exactly the point of it. You forego an optimized return in order to have dry powder post ante a Black Swan event.

Because you might have to reload the right side of your barbell periodically, it is important there's enough redundancy on the left side.

A common misunderstanding of Taleb is to read him as if he advocates stocking the left side with 1-3 year treasuries and by buying out of the money puts or calls for the right side. Treasuries are often picked as they exhibit low volatility and low volatility equates low risk in finance. Something that's very unfortunate because low volatility tends to be a temporal state. When people talk about low risk, they aren't looking for something that's momentarily low risk.

Typically, I never get close to anything that has no volatility, unless it's justified, like Treasury bonds. If you go to a balance sheet, you can see why there is low volatility, whether it is genuine. The company can have a barbell. The company can have very, very low leverage. Or you might discover that a company is doing the equivalent of selling remote options, and the company can lose a lot of money in one blow.

-Taleb

Taleb allows for volatility in the left side of the barbell but the variations shouldn't affect your welfare (defined as health, happiness and fortune).

I'm not saying you can't have treasuries in the left side of a barbell and perhaps you should, but for one thing, they are extremely vulnerable to hyperinflation.

Practical Suggestions:

Currencies/Cash

What's better than cash? Different kinds of cash. You could hold a basket of a few different currencies; Dollars, Swiss Francs, Euros, Yen, Yuan and perhaps even emerging market currencies.

TIPS

You could hold a position in Treasury Inflation Protected Securities [TIPS] which offer fairly solid inflation protection. Par value goes up with inflation as measured by the CPI. The coupon remains a fixed %. You can buy them directly from the government through the TreasuryDirect system.

Farmland

Farmland or forests could be appropriate holdings. I'm not as sure about land intended for construction or that's urban based as it is more likely to be vulnerable to the same type of Black Swans as your high-risk investments but that's not necessarily the case.

Metals

I'm not so much a believer you should hold gold or you need to hold Lithium but it makes sense to me that a diversified commodity exposure makes sense to diversify the left side of a barbell portfolio. There are a number of interesting ETFs like the SPDR Gold Shares ETF (NYSEARCA:GLD), iShares Gold Trust (NYSEARCA:IAU), iShares Silver Trust ETF (NYSEARCA:SLV), ETFS Physical Swiss Gold Shares ETF (NYSEARCA:SGOL), ETFS Physical Platinum Shares ETF (NYSEARCA:PPLT), ETFS Physical Precious Metal Basket Shares ETF (NYSEARCA:GLTR), PowerShares DB Base Metals Fund (NYSEARCA:DBB) and others but these always come with management fees.

It's as easy as going on Amazon (NASDAQ:AMZN) to get the physical stuff although that comes with its own storage problem:

American Silver Eagle Coins (apparently even allowed in IRAs)

American Gold Eagle

Canada Platinum Maple Leaf

Currently, my favorite way to gather exposure to metals is through streaming companies and I've written up several for The Black Swan Portfolio.

Short Euro bond ETF

This may be surprising but given the current risk/reward equation offered by Euro bonds, I'd say they are a terrific add to the left side of a barbell portfolio. In some cases, a short even offers positive carry. There's very little opportunity for a short on Euro bonds to go against you while a few years of rate hikes would mean solid gains. Theoretically, a short means you can have unlimited losses (although that's very much theory with a bond ETF), technically, it doesn't fit within a barbell framework. Buying puts on bond or bond ETFs would be in line with the barbell philosophy.

Agricultural commodities

Agricultural commodities are very hard to hold at home and ETFs can be a solution here. What I don't like about the Agri ETFs is how the roll cost eats up your capital. I don't hold any of these and instead try to look out for cheap investments in farm company stocks or other agricultural stocks. I own some Trigon Agri (OTC:TRGAF) for example.

Cryptocurrencies

For some people this may be a bit of a no-go area and others swear it is the solution to Central Bank-engineered devaluations. I own a basket of cryptocurrencies as I believe there is both a chance it solves the CB problem and there's a good chance these will become more mainstream as they have technological innovation which drives their usefulness. Also read: 4 reasons to buy Bitcoin. I use Coinbase to hold some Bitcoin and Ether, which is U.S.-based. Try it here to get an extra $10 worth free.

Fixed rate mortgage

Even owning a house with a fixed rate mortgage on it could qualify for the left side of the barbell although having it paid off would ensure it did. With a fixed rate, there is no way for the payments to spiral out of control. You have the option to hand the property over to the bank and you have locked in shelter as long as you come up with the predictable monthly payment. If you encounter a vicious deflationary spiral, you could hand over the keys but a bout of hyperinflation means you got your house for free.

Some final words

What should/could be great investments that ensure you don't go broke, can reload, have the purchasing power you need to live is up for debate and somewhat in flux. It's okay to make judgment mistakes as even these assets need to be diversified. However, these safe assets should under no circumstances be the collateral or a means of recourse when your aggressive investments fail. Your aggressive investments can have leverage but NOT at the portfolio level or it defeats the purpose of the barbell.

Make sure that the probability of the unacceptable (i.e., the risk of ruin) is nil

-Ray Dalio

Disclosure: I am/we are long IAU, TRGAF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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