“Prepare for the worst, hope for the best.”
Most of us ascribe to this philosophy. We purchase home, automobile and life insurance policies, paying a small premium every month to protect ourselves in case of an unlikely yet potentially catastrophic event.
Unfortunately, most people are failing to safeguard their investment portfolios in the same way that they’re protecting their homes or cars. For most of the past 50-plus years, investors could balance their risk profiles simply by putting their money in a 60/40 stock-bond allocation. But those days are gone.
Since the global financial crisis and throughout COVID-19, interest rates have been low. In this kind of environment, traditional safeguards—gold, bonds and Treasuries—no longer provide an adequate buffer against volatility in case of a market sell-off.
At the same time, the risks of ignoring a downturn remain real. Between 1929 and 2020, there were 26 bear markets in the S&P 500—defined as the index closing at least 20% down from its most recent high. That’s one bear market every 3.6 years, according to Ned Davis Research.
The good news is that bull markets are more frequent and typically last much longer than bear markets. But even if you know, intellectually, that a market correction or downturn will be short-lived, many investors—especially those nearing retirement—still have trouble sleeping at night. For investors who planned to retire around the 2009 stock market crash, the previous 10 years amounted to a “Lost Decade.”
What’s the solution to risk mitigation in a low-interest-rate environment? Many individual investors—working with their advisors—have been following in the footsteps of their institutional counterparts, purchasing volatility-risk protection, also known as tail hedging. For example, an investment portfolio with an allocation of 90% to equities and 10% to predictable uncorrelated asset classes that has built-in tail hedging (i.e., portfolio insurance) can provide enormous protection. If that 10% allocation increased to 30% during market turmoil, it acts as a hedge for the equity portfolio and allows the investor to reallocate capital, buying stocks at lower, more attractive prices. The result: You become a buyer when everyone else is a seller.
With any kind of insurance, pricing is key. Pay too much for insurance and it quickly becomes an unnecessary expense worth cutting, especially when times are good. That’s what happened to CalPERS. In October 2019, several months before the pandemic caused a massive stock-sell off, the California Public Employees’ Retirement System cut its tail hedge and missed out on a $1 billion payday. But when you invest in “loss cancellation,” a portfolio can be more heavily allocated to stocks in the first place, which effectively pays for the price of the protection.
Tail hedging turns crisis into opportunity. Most importantly, it takes away a lot of the emotion, which, for an investor, is like poison. When emotions run high, investors become fearful. They sell when the market begins falling and buy when prices go up again, completely missing out on the ROI. It’s the same reason why stocks fall a lot faster than they rise. Fear is a more powerful motivator than greed.
If you can invest a modest amount of capital to protect your portfolio against a market sell-off, you’ll feel freer to make smart investment decisions without worrying that all your hard work will go up in flames. You can treat your financial portfolio the same way you treat your home—confident that should the worst happen, you’ll be protected.
Christopher A. Zook is the founder, chairman and chief investment officer of CAZ Investments, which allows RIAs and high-net-worth individuals to invest in private equity, real estate and other exclusive opportunities traditionally available only to large institutions