EDITOR NOTE: A fat tail is simply a low-probability yet extreme occurrence whose consequences can yield significantly destructive or beneficial payoffs. In terms of negative payoffs, we can take simple actions to thwart its effects, such as wearing a seatbelt--the probability of a major accident may be rare, but should it happen, its “impact” can be significant enough to take you out of the gene pool. Right now, people are jumping into the market without wearing a proverbial seatbelt, completely ignorant of tail risks. And similar to “Mother Nature” itself, the market has a way of taking unfit or careless creatures out of its proverbial gene pool. The question is, are you one of them?
‘If you don’t have a tail hedge, I suggest not being in the market [as] we’re facing a huge amount of uncertainty.’
That’s “Black Swan: The Impact of the Highly Improbable” author Nassim Nicholas Taleb offering his view on the risks swirling in the market and a growing lack of clarity about the future in the era of a deadly pandemic that has created a public health and economic crisis.
Speaking in an interview on CNBC on Friday, the popular author shared the notion that investors should be hedged against so-called tail risk, which refers to extreme events that, among a distribution of outcomes, have a low probability of happening. Taleb has spent his career chronicling “tail risk” events, which can take place more often than one would guess, and therefore often are underestimated by the broader investment community.
Taleb said the current market landscape, perhaps, has amplified uncertainties, even if the stock market has been mostly rising, despite signs of a spreading COVID-19 pandemic that is re-intensifying in places and threatening to derail projections for a “V-shaped,” or quick and sharp, economic recovery.
“We are printing money like there’s no tomorrow,” Taleb said, referencing the Federal Reserve’s efforts to ease the financial pain of the epidemic by delivering trillions of stimulus to the market. The Fed also cut interest rates to a superlow range of 0% and 0.25% back in March, and may not have a lot of room to further ease the economic pain of the viral outbreak and other problems that could arise amid this crisis.
“And COVID seems to be there even if the pandemic … dies down, [so] you will still have people cautious enough that it will impact a lot of industries,” he said.
Hedge funds that are designed to benefit from tail risks have enjoyed a remarkable run-up in the age of COVID-19.
For example, the Cboe Eurekahedge Tail Risk Volatility Hedge Fund Index has returned 48.19% so far this year. By comparison, the Dow Jones Industrial Average DJIA, -0.12% is off nearly 12% thus far in 2020, the S&P 500 index SPX, 0.38% is down 6.2% and the Nasdaq Composite COMP, 0.76% is up about 10%.
Meanwhile, Universa, managed by Mark Spitznagel, saw an eye-popping 4,000% return in his tail-risk fund during the height of the pandemic. Taleb has been an adviser on that fund.
To be sure, protecting your portfolio from such tail risks, rather than betting on them, may be key. Investment funds that have attempted to solely wager large sums on market turmoil have tended to underperform, the Wall Street Journal notes. That’s because those bets on sharp declines have failed to benefit from subsequent rebounds in the market.
Originally posted on MarketWatch