How to protect your portfolio from Black Swan events
Ever seen a Black Swan? No? There’s nothing wrong because they are rare. Black Swan events are rare events too. And black connotes negativity. So Black Swan events are all those events that rocked the stock markets across the world. Know of any of these?
Classic Black Swan events include World War I, 2K internet issues, and the September 11 attacks. Natural disasters such as Hurricane Katrina, failures of markets and national economies such as Brexit are all macro events that occur with or without warning and with far-reaching global ramifications.
What about India? During the financial crisis, 2007–2008, the stock markets in India fell on several occasions. In 2007 alone, there were five sharp falls in the stock markets. Even a few years back, the Indian stock markets crashed. For instance, on 9 November 2016, Sensex crashed by 1689 points due to the crackdown on black money by the Indian government. This was the demonetization drive by the Modi government. The weakening rupee and the US presidential election too had some bearing on the behaviour of investors.
More recently, in January 2020, Dalal Street eroded Rs 3 lakh crore worth of investor wealth after US President Donald Trump threatened to slap sanctions on Iraq “as they’ve never seen before.”
You, as an investor, need to be aware of these events. You can protect your portfolio from such events. However, before that, you need to understand Black Swan.
Black Swan events were popularized by the writer Nassim Nicholas Taleb in his book, The Black Swan: The Impact Of The Highly Improbable (Penguin, 2008). He said that the world is severely affected by events that are rare and difficult to predict. This affects markets and investments.
During these events, people develop a psychological bias and collective blindness to rational behavior. The very fact that such major events are by definition outliers makes them dangerous.Investors need to realize that these events outside of the market present a much greater risk than the inherent dynamics of the market.The challenge for investors is that the uncertainty caused by these events is not measurable in terms of their potential risks.In the past, we might have experienced a Black Swan once every few decades, they seem to be occurring with more frequency now.Learn how to mange your money & create wealth, Download your FREE eBook now
How does it affect your portfolio?
If your portfolio mirrors any of the broad-based indices, the market crashes might result in a fall in your portfolio. Even a concentrated portfolio could get affected. For instance, many investors only look at the classic 60-40 equity debt portfolio as the standard for a relatively ‘safe’ portfolio. Such portfolios have had one-day losses of 4-5 percent. More importantly, a study suggests that there is a loss probability of 15 percent and there is a very small probability of even a loss of 35 percent. That’s why you need to protect your portfolio from Black Swan events.
What you should do
Have a proper mindset
Consider the most successful investor of all time, Warren Buffet, who has made billions by buying while everyone else was selling wrote: “Fear is the foe of the faddist, but the friend of the fundamentalist…” So, don’t let fears rule your investment decisions. Make rational decisions after analyzing market impact and stock/mutual fund fundamentals.
Also read: How Procrastination Affects Your Finances
Keep your liquidity intact
Cash is still king. So be a loyal subject and keep it where you can easily grab it.Do not keep it at home or let it be in your savings account. Consider keeping money in liquid mutual funds and fixed deposits where you can easily reach it. Preparing for Black Swan events requires more liquidity than you might realize. A Black Swan could disrupt your job or source of income. So, keep at least 6 months of your salary in liquid assets. Do you know there is another advantage? Having ready cash gives you the flexibility to take advantage of lower stock valuations.
Don’t listen to everyone
You have the stock gurus, the social media and the guys at the cafeteria talking about the markets everyday. Understand that all that noise has very little to do with your financial goals and objectives. Set a strategy based on your investment objectives, goals, priorities and risk tolerance. Remember that these are the only benchmarks that matter.
Diversify, diversify, diversify
Diversification is not simply spreading your money out among a lot of equities and debt securities. You should structure your portfolio with varying types of asset classes that act as counterweights. This will help in responding to different economic or financial circumstances. For instance, a macro event that sends the markets plunging might likely drive up the price of gold.
For peace of mind, gold may be the ultimate tonic. Gold can protect against events that put the world in turmoil. As part of a predetermined strategy, commit 5% to 10% of your portfolio to gold.
By adding different asset classes, your overall portfolio will have more stability over time.Diversify across industries, themes, types of investments — so your portfolio has enough defensives. Registered Investment Advisors such as Mymoneysage can help you diversify your portfolio.
Do not try to time the market
Most investors try to sell near market bottoms and buy near the tops. This technique simply doesn’t work. Stay with your allocation strategy and use market declines as opportunities to rebalance. You can use market rallies as opportunities to capture some gains, but always try to keep your allocation the same.
To mitigate risks, consider variable annuities, structured notes, and hedging strategies.An alternative strategy or investment that secures income stream or allows you to stay invested is a good idea.
Sell the winners and buy the losers.This portfolio strategy, known as “rebalancing,” can keep your riches from becoming rags.Rebalancing forces an investor to sell high and buy low, which after all is the goal. This restores asset-allocation targets that market movements might have changed. Rather than rebalance every six months or year, do it when allocations move 3% to 5% from target levels.
Stick to goals
Invest for your life purposes, and keep your eye on your goals. That is the only thing that matters. You don’t need to chase market returns or that latest hot stock or mutual fund. If your portfolio is giving the returns you need to achieve your long-term investment objectives, what does it matter if other stocks/funds are doing better? There is a good chance that hot stock/fund will under perform the market next year.
Mind the biases
Avoid hindsight bias. Read more about this bias here – How hindsight bias affects your investments. Be realistic about what you knew back then. Don’t place too much faith in predictions. Predicting financial markets can be done, but their accuracy is a matter of luck and intuition. Rely on intuition, common sense and simplicity.
So, make your investment portfolio as crisis-proof and black-swan-proof as possible. Our old techniques—diversification, ongoing monitoring, rebalancing and so on—are less likely to let us down. Understanding that the most reliable prediction is probably that the future will continue to remain a mystery, at least in part.
Preparing your portfolio for the uncertainty of Black Swan events is not as difficult as you might think. However, investors who have moved away from the fundamentals of long-term investing may find it challenging. You can take the help of financial planners to minimize your risks, get higher returns and help keep track of your portfolio.