‘Heads I win, tails you lose.’ In this uncertain time, investors are facing a lot of volatility. We often discuss using tactical management and algorithms to prevent losses but what other tools are available? How can we win when the market goes up and when the market goes down? We can always be certain the market will do one of three things: go up, go down, or go sideways. So we have to prepare and properly protect ourselves for all three outcomes. On today’s episode, we’ll discuss the value of a tail hedge, managing tail risk, using a tail hedge versus an algorithm, and how this insurance tool fits into your overall portfolio construction.
Facing a black swan event and managing loss becomes much more significant as you reach retirement. In the same way, we protect our home, our car, and our health with insurance we should also be protecting our portfolio. By managing your tail risk, you are able to utilize insurance within your portfolio. This allows you to stay competitive when the market goes up and you will continue to make gains when the market inevitably goes down or sideways.
With a tail hedge, if you experience a 20% loss, your returns are made while the market is going down rather than when it is coming back up. A tail hedge can allow for a 75 to 25 allocation that outperforms the cost of the insurance, mathematically it’s a sound decision to implement within your investment strategy. Putting together a diversified and properly allocated plan with budgeting, cash flow, inflation, and protection all taken into account is more essential than ever.
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Timestamps (show notes):
1:13 – Spring is coming!
4:55 – We are going to discuss ‘Tail Hedges’
5:35 – What is a tail hedge?
11:54 – How do we manage a tail risk?
16:10 – Tail hedge versus an algorithm
20:52 – What are the costs like?
24:15 – The importance of proper portfolio construction
31:01 – Some closing profound thoughts
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Welcome to Retirement Talk, the Redefining Wealth Show, your source for financial information specifically for pre-retirees and retirees. We are here each and every week to help you better navigate during these economic times. We’re here to discuss thoughts and ideas in the field of finance and retirement, as well as discuss trending topics that can impact your bottom line. We will break it all down. These discussions can help you make better informed decisions so you can make better financial choices and live the lifestyle you imagine for retirement. Laura Stover is a registered financial consultant and CEO of LS Wealth Management, as well as founder and owner of LS Tax, a consulting firm. She’s been featured in Forbes, CNBC and The Wall Street Journal. I’m Ron Stutts. Our topic for today is what is a tail hedge? A discussion today for investors amid a huge amount of uncertainty and how it can protect your portfolio. Now here’s your host, Laura Stover along with certified financial planner, Michael Wallen.
Hello, hello, hello Michael. It’s great to have you back in the studio with me here today. How are you?
I am doing great, Laura and glad to be back. And you know, you said a couple of weeks ago that if we would just be patient, these days were going to get a little longer. Sunshine would shine a little bit longer in the day, it’s going to get warmer and you were spot on. Today is a beautiful day and it feels like the first day of spring.
Well, we’ll maybe try to pretend that it is the first day of spring. I have been doing that mind like envisioning what you really want and I don’t know what they’re… There’s some books on me manifesting your thoughts or something and that might be a great topic for another show. But yes, indeed, we’re hitting the seventies up here in the Northwest over the weekend. So hopefully when we step into spring, hopefully that is the sign of more joy and good news because I think a lot of people could use that these days. There’s so much going on. And before we went on the air, we were discussing our engineer. He was pretty sick with COVID and we’re glad that Dan is back. So we have a lot to be grateful for. When you look around at everything going on in the world and everyone, when you have stress and problems and everyone thinks, oh, my stuff is the worst, but there’s always somebody worse off.
And hopefully the COVID is diminishing and no one wants to be sick, regardless of whether you think you should be vaccinated or not, no one wants to be sick. And then when we look at what has transpired since you were on the show with me last, with the geopolitical issues, absolutely devastating. And that’s another show on itself. I do believe that we’re going to have ramifications on some levels, those are yet to be seen. But one thing that came out on a news broadcast that I saw, a Senator, I won’t name any, because I don’t want to detour with political opinions at all, but he made a good point. So the SWIFT was enacted with part of the sanctions and that’s the way transactions are done in the banking world. It’s a pretty big deal. But now that we’ve implemented that, does it potentially set China up to be the stronger number one currency, where they invent a platform where they can function in that capacity? And I’m like, I think that is a valid point.
But I think it’s the best decision, obviously at this stage. And we are seeing a lot of market volatility because of the uncertainty. So our show is timely for today and we want to talk about the market volatility, but more specifically, maybe some tools our listeners are not familiar with. It’s about compounding returns and when you lose capital, too much capital. Yes, staying in the market long term has always proven to be beneficial. We discussed with our guests last week. I mean, there was five wars in the past and all the precursors to each of those big dips, the market went down substantially, but came back up over time. But your compound returns, like on episode, I think it was 92, when I had to go through the math calculation, you have more dollars. Percentage returns and dollars are two different things.
So our key topic today is in terms of calling this tail hedges and it’s actually a tool that has been around. It’s not exactly a new concept, but we often talk about tactical management algorithms on portfolios to prevent huge losses that are devastating 20% or more. Tail hedges are a little bit different. They can be utilized all of the time. We’re going to hit the pros and the cons in terms of how tail risk could really be implemented into the growth side of your portfolio. And then portfolio planning, I mean, it does come down to having that plan. What should that look like? So without further ado, let’s hop right in and I have good memories for the most part. Although believe it or not, mathematics was not my favorite high school topic. I find it fascinating now.
When we look at what distributions in the financial world, we’re all familiar with that bell curve and that’s basically the averages. Most companies use this to measure. You can know you can measure employee performance. But a bell curve in the financial world is really something as a concept on the means and what the average return should be. So putting this into perspective, let’s explain first, Michael, what a tail hedge is. I’ll give you the hard part here.
Well, my brother, he introduced me to the tail hedge many, many years ago. I think I was about four years old and the concept was heads I win, tails you lose. And a tail hedge, what we want to do is in portfolio construction, we want to put an element inside of that portfolio that if the market goes up, heads I win. The market goes up, I’m priced into positions and it’s going up. But I also want to come in there and have that well, tails you lose component, which is really buying insurance. And that is putting an option inside of that that if the markets really take a dive and that’s oftentimes when we see a standard deviation that may be a four, five or six deviation, which if we get out to a six deviation, that’s what we refer to as a black Swan.
And that black swan is very problematic. It is very hard to predict. Those are those really far outliers of that bell curve that you were talking about. So inside of it is we know the market’s going to do three things. And Laura, you teach this all the time. The market’s going to go up, the market’s going to go down or the market’s going to go sideways. When the market goes sideways, there’s just not a lot of protection because the normal volatility of the markets between that 10%, you should expect the volatility of the market every year to have a momentum of 10% swings. But it’s really when you get into a movement like we saw on January 2020. On January 2020, the price of the S&P 500 was at 3225.52. We experienced a black Swan. We were introduced to COVID. It was an outlier. It wasn’t something we were experiencing.
And on March 1st, 2020, the price of the S&P 500 had dipped down to 2584.59. That was a 19.87% loss in the market in a 60 day window. Now we talk about a lot of times on the show, people get emotional, they want to jump out of the market. If an individual would’ve jumped out, they would have absolutely locked in losses where we were nearing a 20%, almost a recessionary mark. But if they had waited until the end of December, the value came back on the S&P 500 to 3714.24, which was a 15% increase over the January one mark, but it was a 43% increase from trough to peak. And that’s why staying in the market is beneficial. But for a lot of retirees, you don’t have the luxury of having a huge loss. So what you do inside of that is you build a tail hedge and you buy insurance inside of that portfolio that if you experience that 20% loss, you’re actually making your returns when the market’s going down and not necessarily when the market was going back up.
Yeah. So these events, unforeseen wild moves, the market makes wild moves up and obviously down. So this is an opportunity even when the market goes down in some instances to make a profit. It’s a little more complex, but we’re going to keep talking about this here. And if you’re anything like me, I mean, we love the days when you make a profit, but days when the market just goes down, sometimes days on end, if you’ve experienced a market crash, if you’ve been an investor for some time, I’m sure you have experienced those days. That can be very frightening, can be painful. And it’s these events of unforeseen market crashes just simply cannot be predicted, but they can be very devastating, especially if you’re taking income or withdrawals on the portfolios. So you need some hedges and a variety of strategies.
We’re talking about this potentially as one component to a portion or segment of an overall portfolio. And we’ll explain that more in the financial portfolio planning part here shortly. But tail risk, then, those days when the market makes a significant move from the mean to the downside, and it’s actually a popular term these days. And whether you are a real estate investor, you’re going to see periods such as the COVID pandemic that could have ceased your rental income for months on in. Maybe you are an online business, well, then there’s actions from regulatory bodies or breakage with optical fiber cablings and such that could disrupt your business. And those are what we would call black swan events. So the concept here is certainly not new. And we believe very, very strongly, we probably talk about this on almost every show, that managing losses, because they become much more significant especially as you’re nearing retirement or in retirement even than gains, losses hurt more.
And again, refer back to, I believe it was episode 92, when I put Michael through the math percentages and dollars there. Now, tail risk hedge, how do we manage a tail risk? We cannot certainly account for every single thing that could go wrong, but anything we can do to manage a risk in the stock market. It’s about mathematical probability. So let’s explain this a little bit more Michael, the same way we protect other important things in our lives, whether it be our cars, our health, our homes, it’s really the idea of buying another financial instrument. And it’s really embedding that insurance within the stock market. And it takes the form, as you stated, something called a put option. You can buy a cheap put with a strike far away from that trading price and when the market makes an unexpected giant move downwards, then those put options, see their prices rise by many multiples of their initial costs, and that technically would offset potentially those losses the market crash may otherwise have caused you. Let’s elaborate maybe on that idea a little bit.
Sure. Again, it’s going into investing. I think all investors need to understand that there is a potential of losing. That means that if there’s a potential of losing, the market is not always going to be in your favor. And if you’re invested, you’re buying positions in a company, whether it’s individual stocks or a mutual fund, or an ETF that is all banking on upward trajectory of that pricing, then you are leaving out the other side of the coin, which is, what happens when the market goes down? And you can have a well diversified portfolio. A lot of investors have been in a 60/40 asset allocation, and that worked well in the past. However, with the volatility we’re seeing today with the global presence of the economy, with things that are happening, that impact the movement of the US dollar, impacts our economy, impacts our stock market.
What we’re finding is that 60/40 may not be the best position today. If you’re using a tail hedge, oftentimes you can even go as high as maybe a 75/25 allocation with the same protection that you once had to have a 60/40. And who really wants to have 15 to 20% of their portfolio really sitting on the sideline that can only benefit you in a down market where if it was on the positive side, that extra 15 to 20% of asset allocation, would yield you a much greater return. So again, like you said, Laura, it’s a very mathematical high probability type of scenario that we’re looking for, have that level of insurance around your portfolio, that when the market has those very large drops, and as the drops go down, remember your actual returns go even higher. So if the market’s going to go negative, you want to fully bet against the market at that time, because your returns could be 200, 300, 400% higher, than even if the market had been favorable and you may have experienced a 15 or 20% return. So you can make money in either direction.
So tail hedge benefits, hedging the portfolios tail risk is really about avoiding those big losses and benefiting greater compound returns and increasing where you have the ability then to increase that equity allocation. Because obviously over time, that’s typically and historically what has been a stronger return, why thus white people like stocks, or whether it be ETFs. This can be implemented on a variety of underlying investments, but the allocation then would really decrease the portfolio’s total systematic risk and ultimately generate higher returns, if you can have a stronger equity presence within the portfolio.
Now, I want to talk about two things here before the break about cost involved. There’s always that part of the discussion that’s important. But how does a tail hedge differ from an algorithm? We’re fans of utilizing both and an algorithm is a proprietary intellectual property that money managers have and it’s typically rules based. Based on certain percentages, typically when the market goes down, it will trigger and likewise to come back into the market they trigger. So it’s more of a timing issue, a market timing issue with algorithms. And how does that differ in your view from the tail hedge? And they really can be a nice compliment to one another.
Well, the algorithm, what we’re looking at there is what historical data has shown us. Now it’s not 100%, we’re using probability in that as well. So if we’re following what trending is, we’re looking at investors out there that typically have the same behavior, emotional dynamic. So if we know that if the market is trending down and we are following, whether it’s the 50 day, the 100 day, the 150 or the 200 day moving average, we’re looking at the average pricing. And historically we know that along with a movement against the price and if there’s an inverted yield curve, it is an indicator that we are going to see more movement in a negative way. So the resistance and support in technical trading is what we’re looking at there. And so that support set the floor that you’re standing on. If you kept jumping on it, jumping on it and jumping on it, and you finally broke through the floor, you don’t know how far you’re actually going to fall. And it’s the same thing.
I don’t want to fall at all. These days, if I fall, I might not get back up.
That is true. I understand. But in investing, we are going to fall and then we’re going to get back up. But if we ever break through the floor, we don’t know how far that is, and we’re going to set a new low when we do that. So that’s where the algorithms come in and for those individuals that really, they have a very low threshold of any loss in their portfolio, that’s where an algorithm could come in and basically say that if my account drops below this point, I’m willing to get out even if it costs me a slower return when the market’s recovering. Because typically in that first two weeks of the market recovering, we see six to eight of the best return days. So that’s where you know you’re going to lose some returns. Now on the tail hedge, you’re not actually leaving the market. You’re just putting another component in there that can make up those losses if we see those major drops.
And in the example I shared earlier, when COVID hit investors would have been and again, we have to preface this Laura, by saying, we have the luxury of looking in the rear view mirror at what did happen, not what’s going to happen. But a tail hedge for investors in January when COVID presented itself of 2020, they would’ve been better with a tail hedge than if they had been in an algorithm. So that’s where you just have to weigh in between the two of where is that investor, which tranche of money are we looking at? Because if we’re looking at the third or fourth bucket that a person has, in large way, that’s probably tail hedge opportunities. If we’re looking at money that we need for income today, and we really can’t afford any losses on it, either a strategy out of the investment or having algorithm may be more beneficial to them at that point.
You’re listening to Retirement Talk, the Redefining Wealth Show. I’m Laura Stover with me certified financial planner, Michael Wallen. We’ll be right back with a discussion continuing on tail hedges, portfolio construction and fees. You’re listening to Retirement Talk.
You are listening to the Retirement Talk Podcast with your host, Laura Stover. Get a copy of our How to Survive a Bear Market guide, email [email protected]. That’s [email protected]. Request your free copy. Now back to the show.
We’re discussing the concept of tail hedges, and that may be a new term. Maybe you’ve never heard of that. And so let’s take this and dig a little deeper under the hood, and we believe a variety of tools. I want all the tools possible. Everybody’s situation is unique, just like our fingerprint. And it’s good to have all of these tools available so that you have the most well constructed portfolio, but in the timeframe we’re in, volatility, whether it go up or down has really been monumental. I mean, we’ve seen a lot of movements of 600 points, 1,000 points that used to be a rare anomaly like 1987. A 500 point move crashed the market. They call it, what, a Black Monday. That’s like nothing in today’s market. Yes, we have a much larger market cap, but nevertheless, 1,000 point move now per day definitely is much more meaningful.
So with some of these tools, cost vary, and we’re very fee-conscious with our firm. I believe that if you pay a fee, it needs to be worth value. It’s value in the fee rendered. And there’s a variety of cost and I mean, it’s quite simple. If you are making more dollars, is it worth the cost? We’re in a fee compressed environment and I think you can have access to some of these world class tools in today’s market environment, much less expensive than in probably times in past years. Would you agree?
I would. When you’re looking at the portfolio construction and you’re adding a tail hedge, like we had just mentioned before the break, if you take that old typical 60/40 allocation model. But now if you’re using a tail hedge, a put option inside of it, and you can go to a 75/25 allocation. It very much outperforms that extra 15% of the allocation in the favorable years of the market, would be much greater than actually what that insurance cost would be by putting that put option in. And so you’re using a portion of your portfolio designed to benefit you when the market goes down. And if the market does it go down, that’s okay because that’s just lost premium there, but you’ve allocated 15% more towards your equity role in your portfolio. And because of that, you’re way outperforming the cost of what that put option would be. So mathematically, it is a sound decision as you look at tail hedging for that level of protection, and that’s why options were created, whether you’re buying an option or you’re getting a put option.
And if you’d like a strategy, consultation and to speak with Michael and myself about some of this, if you’ve never heard of it before, if your advisor isn’t familiar, we’re happy to speak with you to see if some of this would benefit you in your situation. Feel free to go to redefiningwealth.info, click schedule a 15 minute strategy session. I think it all comes down to between tactical management, between tail hedges as a segment. We’re big about segmentation. Whether we need some guaranteed income, for income in certain situations, or we need to have a certain amount of income maybe at a specified time, like three or five years or seven years down the road. If we need to have long term care to pay for healthcare in our retirement plans, if we need to have a tax plan this year, do we do a backdoor Roth? Is it going to be reverted according to some experts, retroactive back to January of this year if you do backdoor Roth conversion? Which is another show, we probably need to discuss some things going on there in the tax world.
We’ve been deterred with all of the geopolitical lately. It all comes down to portfolio construction. So I want to wrap a few moments around this concept. Michael, I think we do a really, really good job when it comes to portfolio construction and really the way portfolios need to be put together in the planning process. It starts with that discovery call, obviously, getting to know the client, making sure we’re both mutually a good fit at this stage. And we work with clients nearing retirement or in retirement. And that process, the way we go through the budget, the cash flow, knowing the inflation component, is it good that we are really big about having the inflation calculated into the portfolio?
I had a client just recently. They didn’t really think it was important to be accurate with their numbers. They had a $20,000 deficit stepping into retirement. I’m like, you need to go back into a life hack system. I don’t believe you’re spending 10,000 a year just on your transportation. They don’t fly, they don’t go anywhere. So getting these numbers right makes a huge difference when you’re stepping into retirement and knowing the sources of that income, how it’s going to be taxed, what’s the overall effective inflation on it. But putting this plan together is more essential than ever. And it shouldn’t just be on one recommendation. You have to just… When I go to the doctor, if he’s going to make a recommendation, I want a thorough analysis. I am not taking any kind of pill these days, unless I know exactly what the benefits are. What is the potential side effects? How is it going to help me improve my situation? And that’s really the approach.
It’s not just product driven, but a plan puts these types of things into the overall picture. It should have the ability to adapt, have liquidity. If you’re paying some fees, understand the value of the fees that’s being rendered. Digging under the hood and going through a process is more important than ever in getting this right.
Through the LS Wealth Process, we discovered the other day as I was talking with a client, and it was very similar to looking at their portfolio construction. They had been working with a broker, Laura for several years. They came in and I just asked them right upfront before we had started digging in. Was like, “How do you feel about your investment strategy?” And they shared with me, “I am so well diversified. I think we are doing a great job here.” And so I started uncovering it, looking through the analysis and I said, “Well, I see here that you’re in five different mutual funds.” And they said, “Yeah, they have got me well diversified.” Well, those five mutual funds were all large cap. They were not diversified at all.
I was going to say when they say, well constructed and well diversified, that’s code word for hodgepodge syndrome usually, but continue.
Yeah. They were well allocated. They were allocated among five different mutual funds, but the mutual funds were holding the same underlying position. So when we did our correlation matrix to really see, how are you invested, we found five different mutual funds investing the client’s money in the exact same underlying positions. And one thing that maybe as a bonus, maybe we should drop out on the site for people to go to, is our investing periodic table. And then that investing periodic table, if you look over the sequence, because I turned this form around to the client and I said, “Tell me the pattern of all the large cap, small cap value, growth stocks, REITs, all the different investing solutions that are out there.” I said, “Tell me what is the pattern that you see?” Well, of course, when you’re looking at these year over year, over year, last year’s winner is this year’s loser and there’s just no rhythm or rhyme to being able to select the asset class that’s going to always be best.
So when we look at construction of a portfolio, you cannot be invested just in large cap. You cannot be just invested into value because you are going to miss the returns as momentum and opportunities present itself through those other asset classes. That’s what construction of a portfolio needs to consider. And it needs to have an element of all of those asset classes built into it so that when the market is up, you’re gaining from those areas. But you’re also not losing out because you’re a one dimensional investor looking solely at growth stock or just at value stock. And I believe that’s what the true diversification needs to look like. To be allocated is not to be diversified.
Asset allocation and diversification are two different concepts. A lot of times people do indeed confuse that. Asset allocations about 93, 92.6, to be exact, Michael, have how well your portfolio’s going to do over time. Diversification is how you’re dividing up what you need for income growth. That’s where you dig under the hood, much, much deeper to put a proper plan in place that addresses all of the six pillars that we’re all going to face in retirement. Our redefining wealth framework helps to identify that.
And some closing thoughts by two people that I would deem really know a thing or two when it comes to profound thoughts. The most powerful force in the universe is compound interest by the great Albert Einstein and never lose money, Mr. Warren Buffet. It shouldn’t be a question if markets will crash again, the real question is when is it going to happen? And the bigger question for you listening, are you prepared for it? And again, just remember investing over long periods by making smart capital allocation decisions can thereby generate higher annual growth rates, avoid big losses, and that will help you at the end of the day to grow and protect your nest egg.
You’ve been listening to the Retirement Talk Podcast with Laura Stover. For a copy of How to Survive a Bear Market guide, email us at [email protected]. Request your free copy now. That’s [email protected] for our guide on How to Survive a Bear Market. Redefining Wealth is a registered trademark of LS Wealth Management. Take advantage of a complimentary plan. Know where you stand regardless of the market. Walk through the Redefining Wealth Process and have a clear picture of the key risk you likely will face. Achieve a deeper understanding of how to properly plan for these risks with the Redefining Wealth Framework. Schedule a strategy session today by going to redefiningwealth.info. Redefining Wealth as a registered trademark of LS Wealth Management. Investing involves risk, including the potential loss of principle. Any references to protection, safety, or lifetime income generally refer to fixed insurance products, never securities or investments. Insurance guarantees are backed by the financial strength and claims paying abilities of the issuing carrier.
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