How to Survive a Black Swan Event
Market risk happens slowly then all at once
19th October 1987, also known as Black Monday, was the day investors never thought possible: a 22.2% fall in the U.S stock market. It was perhaps the most mysterious black swan event in history as nobody knew for sure why it was happening.
It was a day that most investors want to forget as they witnessed the full force of a global stock market selloff, and how fear sparked more fear creating a self-fulfilling loop of panic selling. Markets reacted instantly and there was no way to get out, unless, of course, you were willing to accept a heavily discounted price for your holdings.
Yet it was just another day at the office for a few smart investors who knew to protect themselves in advance. Like everyone else, they already had a fancy broker and a diverse portfolio of stocks, foreign currencies, bonds, and commodities. But what gave them an edge was their ability to withstand the most contagious psychological force in finance that many investors succumbed to leading up to the events on that fateful day: extreme greed.
When times are good, extreme greed forces even the most rational of thinkers to avoid paying for protection: the failure to sacrifice a few gains to secure profits. Greed turns us into irrational beings so we think we can predict the unpredictable and assume the unassumable, but, in reality, anything can happen at any time, at any pace.
Surviving a black swan compels us to overcome this greed, shielding our investments from any event of any magnitude, whether that’s the U.S subprime market collapsing, a European sovereign debt crisis, or an event that’s yet to occur. But you don’t need to be an expert in math, science or psychology. Protecting your investments doesn’t require complex arithmetic or the latest computer algorithms from Wall Street’s Intelligencia. Instead, it comes down to two approaches: the passive approach and the active approach.
The Passive Approach
The passive approach is for passive investors. For people who live busy lives managing their jobs, side hustles, and kids. Whether you have a pension, a brokerage account, or even a Vanguard fund, all these financial products have exposure to the stock market, and if the stock market falls dramatically — say 22.2% or more — it’s going to impact your investments.
With events like Black Monday occurring every so often, we need to be preemptive so we can sleep well at night knowing we are protected. The passive approach is to utilize long term Options which provide a simple, passive shield against black swan events.
As options are maximum risk instruments, the price you pay for the option is the most you can lose meaning you don’t have to worry about your insurance blowing up as well. For example, let’s say you start with a hypothetical $100,000 portfolio of stocks and the market is up 30% over a year and a half. Now you are looking to preserve your $130,000 for the latter half of year two so you decide to use around 5% ($6,500) of the portfolio as insurance against a market you believe to be overvalued. You obtain $SPY put options that expire in six months, which — at current prices — are a bit over budget at $7,050.
A few days later, and it’s Monday morning. You wake up and turn on the T.V, but unfortunately, another Black Monday is wreaking havoc in the stock market which falls 22.2% over the trading session. This is what happens to your portfolio, with and without protective puts:
Black Monday Without Options Protection
Portfolio Value Before Market Open: $130,000*
Portfolio Value After Market Close: $101,400
Black Monday With Options Protection
Portfolio Value Before Market Open: $130,000*
Portfolio Value After Market Close: $127,727
* Not $122,950 because the option has yet to lose any value.
When the market drops 22.2% your $130,000 becomes $101,400 without protection. But if you bought a put option it’s now worth $27,485 saving you over $21,550 ($130,000-$101,400-$7,050) worth of losses from the crash.
But remember this is just Black Monday. We have yet to see a 50% down day or more in U.S stock markets and that’s when having protection really pays off. This scenario happens more often than you think: recently Argentina’s stock market halved overnight due to the surprise election victory of Alberto Fernandez.
If, however, the world is in a better place six months from now then you’ve sacrificed $7,050, but now you know it’s a sacrifice worth making.
The Active Approach
The active approach, also known as the long-short approach, is the defacto strategy that professionals use to manage risk at financial institutions such as hedge funds and investment banks.
There are only two types of real-world portfolios: long-only and long-short. While with a long-only portfolio you buy and hold stocks, with long-short portfolios you buy, hold and short-sell them. The typical long-short portfolio of a professional money manager consists of around 20 stocks: 10 stocks long: betting that a stock will go up, and 10 stocks sold short: betting that a stock will go down.
Now let’s compare the two styles and see how they fare in a Black Monday scenario. We have a long-only portfolio consisting of 5 stocks, and a 10 stock long-short portfolio consisting of five longs and five shorts. Both portfolios total $100,000 in value.
As you can imagine, each portfolio performed slightly differently on Black Monday. In the examples below, note that we adjust stock moves by their volatility using Beta: a measure of how stocks move relative to the market as a whole. For instance, if a stock moves 20% more than the market on an average day then the stock has a beta value of 1.2. So when the market drops 20% we adjust the value of the stock which, in this example, will lose an additional $640 on top of the market loss of $2,000. Therefore, our $10,000 worth of stock becomes $7,360 instead of $8,000.
A Long-Only Portfolio Example on Black Monday
Ford: ($20,000-(($20,000 * 1.2) * 0.22) = $14,720
Caterpillar: ($20,000-(($20,000 * 1.4) * 0.22) = $13,840
Wingstop: ($20,000-(($20,000 * 1.1) * 0.22) = $15,160
Amazon: ($20,000-(($20,000 * 1.2) * 0.22) = $14,720
Facebook: ($20,000-(($20,000 * 1.1) * 0.22) = $15,160Total Before Market Open: $100,000
Total After Market Close: $73,150
A Long-Short Portfolio Example on Black Monday
LongsFord: ($10,000-((10000 * 1.2) * 0.22) = $7,360
Caterpillar: ($10,000-(($10,000 * 1.4) * 0.22) = $6,920
Wingstop: ($10,000-(($10,000 * 1.1) * 0.22) = $7,580
Amazon: ($10,000-(($10,000 * 1.2) * 0.22) = $7,360
Facebook: ($10,000-(($10,000 * 1.1) * 0.22) = $7,360ShortsMacy’s: ($10,000+((10000 * 1.2) * 0.22) = $12,640
Netflix: ($10,000+((10000 * 1.3) * 0.22) = $12,860
Gap: ($10,000+((10000 * 1.0) * 0.22) = $12,200
Shakeshack: ($10,000+((10000 * 1.2) * 0.22) = $12,640
Walmart: ($10,000+((10000 * 0.8) * 0.22) = $11,760Total Before Market Open: $100,000
Total After Market Close: $98,680
As you can see, a long-short portfolio is the best antidote to a black swan event like Black Monday with only a small drawdown compared to a five-figure loss by being long-only.
But, of course, having the time to learn how to trade profitably using the strategy is an art that only a small percentage of professional investors get to master — and a bigger drawdown is the price the rest of us have to pay.
Implementing just one of these two strategies will help you sleep at night knowing that whatever the market does, you’ll be able to survive the next black swan event. No matter how big or how small and whatever it may look like, both passive and active approaches provide certainty and stability even against a zero situation.
But before we get to implement them, a major hurdle we face is identifying and overcoming extreme greed which, in other words, is the bizarre fear of not wanting to protect ourselves from a financial disaster — the reason why most investors fail to meet their investment goals over a long period of time.
If we can’t eliminate this habit then we can’t implement protective measures that help us manage risk in markets; a risk that could increase at any time in the morning, afternoon, or at night. The period before Black Monday is a testament to this: a nonvolatile, quintessential calm before the storm.