Finance

Tail Risk Investing

The “good old days” may be gone, but opportunities remain

Posted

Remember the “good old days?” That was the time when you knew what to expect from investing. Life felt far more predictable back then; you could base your decisions on information that you believed to be authoritative and reliable.

Things have changed in the investing world. Old fashioned predictability is falling on its head, or more aptly, on its tail.

In the past, when selecting stocks or bonds, you probably relied on statistics that were derived from historical data. This data showed patterns of performance believed to be repeatable over time. Much of the historical data could be summarized in a graph known as the bell curve, which assumed that returns were distributed in a predictable way.

You could recognize the bell curve by its high, smooth symmetrical hump in the middle of the graph that rapidly fell off on either side. Most activity took place under the hump. The long, low tails represented highly unlikely returns – negative on the left; positive on the right.

The trouble for investors is that the bell curve is losing its shape. It is becoming lumpy, not smooth. Or as one investment house (PIMCO) described it – “the bell curve is flattening and the tails are fattening.” This translates into more risk and less predictability, changing the nature of investing.

The economic crisis of 2008 was called a “left tail event,” as it was believed to be an extremely uncommon, negative occurrence. While the crisis not only did not go away but subsequently spread around the globe, the left side of the bell curve bulged. Today’s headlines are full of possible left tail events, spinning off from the 2008 crisis: the collapse of the euro, a hard landing in China, the potential in the US for a fiscal cliff and the reoccurrence of a recession, etc. These are the known dangers, although not predictable ones. Add in a layer of unknown dangers and investors are facing a more uncertain, less predictable world.

Lest we sound too pessimistic, the right tail of the bell curve can also bulge. Right tails stem from positive events, such as a permanent solution to the European debt crisis or a meaningful compromise in the US Congress on taxes and spending. Just as left tails can bring the market down, right tails can result in significant rallies.

One independent research firm, Bank Credit Analysts Research, forecasts mid-single digit returns for the next five years, assuming Europe eventually resolves its messy crisis and a recession is avoided in the US. This is deemed to be the most likely scenario and represents the flattening of the bell curve hump.

Given the uncertainty this picture presents, how can an investor possibly protect against the risk of fatter left tails, while trying to capture a little more upside potential? Here are several suggestions.

Think tactically. Buying and holding stocks will only give you the average of returns over time – while you catch the upside, you can’t escape the downside. Being tactical means that you try to sidestep some of the risks while looking for opportunities for growth. It does not mean market timing. But it does mean being willing to buy and to sell should your research call for it.

Seek income. When the markets are volatile, dividends and interest create returns that cannot be taken away from you as long as they are not reinvested. They help to cushion the bad times in the markets.

Look at valuations. Buying when prices are inexpensive gives you the best potential for upside return. But it is hard to do. It means rotating out of holdings that are doing well (and you feel good about) and into others that have been beaten down (ones you find hard to love). It also means being choosy – not all cheap stocks go up.

Be prepared to invest globally. While the US has been the relative safe haven for investors for the last few years, future growth is shifting overseas, especially in emerging markets. Consider adding to your global positions as the outlook for these markets improve.

Hedge some of your risks, especially if you have concerns about left tail events. Hedges are a newer term for diversification. They are assets that are not highly correlated with your major holdings and are designed to keep your returns relatively steady.

Investing is becoming increasingly challenging. The “good old days” may be gone, but opportunities remain.