In extreme markets, the beneficial effects of portfolio diversification can be diminished — and we’d like to add our thanks to the year 2020 for reminding us of that fact. Confronted by extreme markets, some investors persist with uncomfortably risky strategies and hope that all will somehow be okay. Other investors react with excess caution, forsaking the possibility of future gains by following an overly conservative strategy. But alternatives do exist. Tactically deploying a basket of “tail risk”1 assets can cushion against the worst of market moves while still allowing investors to continue to hold growth assets in their portfolios.
Diversification will remain a cornerstone of designing an efficient portfolio. It fulfils a role in most market conditions, delivering a smoother journey and allowing more return to be earned for the same level of risk.
However, managing the risk of extreme market events requires an explicit tail risk strategy. Such a strategy does not replace diversification, but rather complements it. The critical difference is that, while a diversification strategy is “always on,” a strategy to manage tail risk is best deployed nimbly rather than consistently.
Allocating to assets such as gold, long government bonds, and medium dated volatility futures for short periods of elevated market stress can smooth the path of returns, providing confidence to investors to retain healthier allocations to growth assets through time. The merits of each of these tail risk assets, as well as considerations on how to time such allocations, are addressed below.
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