How will you manage a black swan event?

A Black swan event is a rare, hard to predict, low probability event-http://en.wikipedia.org/wiki/Black_swan_theory

A massive earth quake in Delhi, a major war between India and one of the neighbors, a terrorist nuclear attack in Delhi/Mumbai, a sudden significant contraction of the Indian/world economy, and a major war between any two of the top five economies in the world, are a few examples of the black swan events.

These black swan events are capable of not only killing us but also destroying our networth and leaving us unemployed. Assuming that we would not get killed in such a event, we need to understand how do we deal with them financially? Can we predict them? Can we make profit from them?

We can not predict these events, yet a black swan event may occur in our life time, and we will have to deal with it. Here is a simple strategy not only to deal with the event, but also make huge profits from it.

Let us first understand the series of events (financial) that would take place in a case of black swan event. Let us take two black swan events.

1). A massive earthquake in Delhi

  • A lot of people would be unemployed, may be including you
  • Real estate would crash
  • People who had taken loans to buy real estate may default. Many of them would go bankrupt
  • Banks would be reluctant to give loans, specially to buy real estate
  • Real estate developers would also default

2). A sudden, significant contraction/recession in the Indian/world economy

  • Stock market and real estate would crash
  • A lot of people would be unemployed, may be including you
  • Banks will be reluctant to give loans, specially to buy real estate
  • Real estate developers would also default
  • Both stock market and real estate would be available at cheap prices, specially stocks
  • Crash in stock market likely to be a lot more than real estate

We can hedge against such events, and even make profit by following a few rules and implementing the strategy outlined below-

**Rule#1:**Never leverage more than yournet-worthto buy either stocks or real estate. For example, if your current networth is 50 lakhs, do not take a loan of 60 lakhs to invest in a flat in Gurgaon.

**Rule#2:**Always have 20% of your total networth in gold/cash/international currency etc. You should always keep 20% of your networth in safe heavens. Even a bank deposit may not be a safe heaven in case of a black swan event. Gold may crash. Rupee may lose itas value. Only way is to keep a mix of gold, cash, international currencies like dollars, swiss francs etc. This money should be separate from your investment portfolio, or anyfinancialgoal like marriage etc.

Assume you have followed the rules above, what would you do in case of a black swan event.

**Strategy:**Wait and watch the black swan event to completely unfold and impact the markets. As the stock market starts crashing, some investors still buy hoping to average out. The price keeps falling for a long period of time. Eventually, the investors stop averaging, and the market comes to a stand still. Let the asset prices touch the bottom. You can identify the bottom of any asset by very low volumes, and complete dis-interest in the asset (Stage-1 of an asset cycle-http://goo.gl/oEujd). Once you feel the bottom has reached, invest half of the funds in the stocks/asset. Wait for some time, as you may have missed the bottom. If the prices remain stagnant for some more time, with low volumes, invest the other half of funds as well.

You can apply the same strategy to real estate.

**Outcome:**Once the world around you starts normalizing, the asset value will start moving up. You need to hold your assets (stocks/real estate) at this stage (Stage 2 of an asset cycle). Wait for the environment to be completely normal, and for asset prices to shoot up before you sell them to make huge profits. (Stage-3)

Happy Investing!

Vijay

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Nice article, Vijay

Hi Vijay,

Great article!

Thank You for sharing.

Vinod

Thank you Ayush, and Vinod!

I just typed out a fresh article and then saw this. Superb. Still adding my thoughts. Though mostly repetitive to re energize thinking within VP.

Types of Black Swans

Had some lively discussion on black swans but felt that although many have read the book the understanding of the message is not clearly understood. It seems here most people simply believe a black swan means it cannot be predicted :slight_smile:

So here is a short primer to help understand the types of black swans.

First. The mind altering book by Taleb starts by explaining to you that just because you can see only white swans does not mean that black swans do not exist.

The message is, you can see swans. Just that you can see the white swans. So you have to think of what are the potential black swans.

Since this forum is dedicated to investing, here is a short compilation of thought processes of investing swans.

The Unknowns
Example: A war with another country.
Other examples; currency flash crashes, inflation, deflation etc. There is also terrorist attacks, internal anarchy / civil unrest within the country, the death of a state head etc. Basically, things that have happened at some point or the other somewhere in the world. There are many such possibilities.

We know they are a remote possibility but they can happen. But it is not possible to make investing decisions around it.

The Unknowables
Example: A Nuclear Accident. Remember Chernobyl. There are again many such possibilities. Some of these can be new situations to our country or world which we cannot know in advance.

Again, a remote possibility but cannot plan investing decisions around it.

Solution: Always 15 % portfolio Cash. This can allow some advantage to buy some stock or asset if above two types of situations develop.

The Knowns
The markets will rise. fall. rise. fall. rise. So then we already know of the black and white swans. There is no one who invests who does not know that the above happens. Then why does it keep happening? If we have 100 years of data to prove it, still why do humans fall for it again and again? Because we just do not know when the white or black swans will present themselves so we keep dancing or ignoring / avoiding. Usually due to greed or fear.

Solution: A strong mental framework for capital allocation that helps reduce drawdowns and provides more opportunities. This works for those who are willing to keep the discipline and cannot be built at the drop of a hat. One needs to have planned to a fair degree and decided on the course in advance for these scenarios.

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I think a black swan event can indeed be a golden opportunity to build wealth if one is properly prepared for it when it comes. However knowing when to jump in and when to wait is the art that needs to be mastered, as @valuestudent said ‘A string mental framework’.

Black swans by definition cannot be predicted and do not happen regularly so one cannot wait for it or prepare for it or incorporate it as a part of the investment strategy. You may end up waiting forever.

If you are worried about a black swan and plan on getting into 100% (or substantially large % of) cash, its like staying home all the time to avoid getting hit by a lightning strike. That’s not practical. In situations like these the right way is to buy insurance so in case you do get into a freak accident, your beneficiaries will be taken care of (financially). You should consider your insurance premium as a part of cost of living. As you get older, you should have fewer and fewer liabilities so your need for insurance goes down to 0.

You can apply the same logic to your portfolio. If you want to invest in risky assets to benefit from higher returns then you cannot avoid black swans. If you want to reduce impact of black swans on your net worth, buy a low cost insurance like deep out of the money index puts. In a black swan event, these puts will gain in value (partially) offsetting losses in your portfolio. Most of the time these puts will expire worthless.

Cost of these puts is your portfolio insurance premium. At current prices, it will cost you less than 2% to fully insure your portfolio. Option prices have dropped dramatically in last few months. Normally, it will cost your about 3-4% to fully insure your portfolio from downside. That’t not worth it if your expected return on your portfolio is 12-14%. Theoretically, fully insured portfolio will have an expected return close to risk free rate.

As your portfolio gets big, you can reduce % of risky assets and increase % of low risk assets like short term bonds so your need for portfolio insurance goes down. Once your portfolio becomes large enough so that you are willing to take substantial losses then you don’t need to buy any insurance.

Personally, I am not worried about black swans at all. If the markets go down because of an unexpected event, they are most likely to bounce back as it happened in 2009. Markets were back to pre-Lehman bankruptcy levels in less than 6 months. It’s the white swans that I am worried about. When markets drop due to high valuation or because of an economic slowdown, much of the loss is permanent. But it’s slow poisoning so it’s not as scary as getting eaten by a shark.

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@Yogesh_s I always admire your thinking and implementation.

I have never and neither has anyone I have at home ever used puts or options. Neither have I ever attempted to learn them or their value to a portfolio.

I will study it since it is recommended by you. If you have any data to explain how that works then it would be a great study in itself.

If I can add, I am building a position in NMDC and ITC. How would one go about it? How does the portfolio get some insurance. 2-4 percent is a small price to pay for peace. I have also identified some pharma which is close to becoming juicy but not entering due to lack of knowledge in insuring these positions.

I have written previously about insurance using option collar in the portfolio hedging thread.

I will not recommend buying individual stock put options (and worse yet, sell calls) as these are significantly more costly as individual stocks are significantly more volatile than indexes.

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Thank you. Will make for great reading and learning.

The more I read again and again what you took the effort above to write, the more I understand. That’s golden advise above from you. Already thinking of 1% cost to insure 25 to 50% drawdown possibility instead of full value at a higher cost. Provided the stocks can hold their own at some point. Thank you so much sir. I am sure I will understand it better when I dwell more on what you have tried to help me learn. Best Regards.

Use the attached spreadsheet if you want to calculate cost of hedging your portfolio using put or collar.

Hedging with Index Options (Black-Scholes).xls (38.5 KB)

This spreadsheet uses Black-Scholes-Merton Option pricing model to price calls and puts. Actual prices may vary and sometimes significantly. Expected volatility is an important input to this model. You can use implied volatility from NSE page (Column IV) as close estimate of expected volatility. However, please note that I have observed value of IV on NSE page to be incorrect in many cases. In that case, use trial and error to set value of volatility such that price of options given by the model is close to actual traded price.

Use options carefully. Warren Buffet calls them financial weapons of mass destruction. Buying puts is much safer (but expensive) than collar as later involves selling calls.

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Sir. Much appreciated. And much to learn.

Be very careful with Options - both buying and selling calls and puts. Value investing is all about managing risks, but you won’t find mention of buying puts or selling calls as one of those strategies in traditional literature. Do not buy options until you understand the full impact of leverage and time decay. Options, unlike stocks, have an expiry date. Unless you time the market well, you will end up giving up all your equity profits (and some more) if you keep buying options to hedge your portfolio. (Then there’s commissions and taxes to consider too.)

Another risk management strategy (being proposed by some posters on this forum) is moving into blue chip stocks as stock market moves up. The rationale is that blue chip stocks (within the market index) won’t correct as much as small caps and mid caps during bear markets. Why? Because index funds and ETFs have no option but to keep pumping money into these stocks even during market downturn. This is another strategy invented by fund houses, but has its limitations. Please make some time to read Howard Marks’ latest memo. Howard highlights the risks of passive investing in index funds and ETFs. Passive investing has expanded from 20% in 2014 to 37% in 2017 of all equity fund assets. And these funds are forced into cap-weighted investing and not based on stock valuation. End result is that some stocks end up being highly overvalued within the index. This could be the next bubble waiting to burst!

Sticking to plain vanilla Value Investing (i.e., meaning, margin of safety, moat, management) is the safest bet. If you like NMDC but are afraid to buy in this overheated market, then buy only a small amount. Keep the rest of cash to buy on dips. If you think pharma stocks are undervalued (great fund managers like S Naren are calling pharma a good contra bet), then buy it. Contra bets have a habit of moving in the opposite direction of the market. Good luck!

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Fully agree with this point, more so when many people would not know how exchange costs apply to these instruments. I hope before individual investors dive into the world of options they have a complete idea of its functioning. I hope this recent article helps

Agree on this point too. Even bluechips face sectoral correction. A year ago pharma companies were bluechips but have now faced price erosion of over 50 percent. Similar with many other companies. There is no guarantee in equities and people who take the past as a guide to future will make mistakes

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Hi @Yogesh_s wonderful insights as always

Would you perhaps share any empirical evidences of how these strategies have found to act as a hedge against one’s portfolio?

Wouldn’t a simple flight to safety alternate investments yield a similar hedge effect?

Thanks and Regards
Sreekanth

@vasuadiga

Thank you so much for taking the time to help. I must admit, I never did think that there are so many good people who would be willing to help each other at one place with so much golden advice. Must tip my hat to you guys. Very grateful to have found VP and it’s wonderful members.

I have no experience with options and I agree I must be very careful and take a really long time to understand it before I use it, if ever. Really appreciate your concern and effort to write so clearly to try to help.

At heart, I remain a contrarian (budding) and like price is what I pay, value is what I get and don’t generally complicate investing more than that.

I have a small allocation to NMDC, in fact added another 1.5% of the portfolio value again today. Total exposure is now around 5 odd percent of portfolio. I like NMDC as apart from the usual iron ore prices bottoming out etc, it has in stock what it sells, there is no price volatility in procurement as such. Also, it is to me a safer way to play the upcoming (hopefully) infrastructure story as Steel will be a component of infrastructure growth so I liked this best instead of the other stocks to bet on India’s infrastructure growth. Plus it comes with a lovely dividend and there is hardly any free float stock.

Thanks for the links with the HM memo and also the S Naren article. Yes, actually I felt a couple of the same things. Since business has increased there will be more scrutiny and that will only make pharma stronger in the long run. The whole noise seems to only be around inspections which have nothing to do fundamentally with the business. These large Pharma players are not going to shut shop and go home. They will have to ensure that they become and remain compliant and today large pharma businesses which will be around in the long term are available at a good discount.

The article is a good confidence booster that I am not taking a call alone just on my thoughts, and others who have much more experience are also thinking the same and some more. It makes me feel good :slight_smile:. I will probably enter 2 pharma companies soon or the basket, just waiting for some more stuff to play out to decide which route to go.

Thanks so much. Best Regards.

@Yogesh_s Great efforts in putting up sheets for valuation and hedging both. Its nice of you to share the sheets on the forum for everyone’s use.

I just wanted to ask you, why did you choose option as an instrument to hedge the portfolio when it can be done with the use of nifty futures as well. Nifty futures are liquid and easy to trade. Simple way to hedge the portfolio is by calculating the beta of the portfolio and short the nifty to hedge partially or fully.

I am assuming you are using options I might be wrong as well. So pardon me for my ignorance.

Regards,

I don’t have any evidence showing effectiveness of these strategies but most of the gains and losses in the contracts can be accurately predicted and for exchange traded options there is no risk of default. A well designed strategy should serve its purpose.

Hedging like any insurance is protection against a risk that cannot be managed or avoided. flight to safety is a portfolio management task when risk is most likely to materialize ( from the perspective of the investor). Often, a risk builds up (during bull markets) and materializes unexpectedly and rapidly so there is no chance to take a flight to safety.

Large investors hedge their portfolio so that their downside is limited while they can sell the portfolio slowly in the cash market. for large investors, liquidating positions is not a one click job like most of the retail investors.

For retail investors, a simple flight to safety will protect downside but it will also give up upside. With options, you can keep some or all of the upside while protect against some or all downside. cost will vary for each of these settings. Some investors cannot liquidate because of costs, taxes, legal or regulatory constraints etc so they prefer to hedge.

An essential feature of any insurance contract is unequal payoff. i.e. your premium is a fraction of the sum insured. When insured event happens, payoff is much larger than premium. If insured event does not happen before the policy expires, loss to the buyer is limited to premium paid.

Options work the same way. If index drops, long puts pay off huge. if underlying goes up (or does not drop much), buyer’s lose is limited to premium paid.

Futures on the other hand has equal payoff. Gain or loss on futures contract is exactly same as gain or loss on the underlying. One can use futures to lock a price for a trade will be executed in the cash market in future(price hedging) or use it as a leverage (speculation).

Futures can also be used to implement tactical asset allocation similar to a temporary flight to safety or flight to risk but it is not an insurance product.

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