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The conventional approaches to limiting downside losses, such as put options, portfolio insurance or market timing, are either too costly or cumbersome to implement. We propose a “black swan” strategy that combines Treasury securities with equity call options in a barbell fashion.

We show that this strategy has effectively limited losses during periods of extreme market stress, while participating in a significant portion of upside during equity bull markets.

Avoiding losses

Ten years (and 300+% later) into the longest bull market ever, the memories (and lessons) of the 2007-2009 shock waves are slowly being relegated to the back recesses of investors’ memory banks. However, astute students of financial history recognize the movie we saw during the Great Financial Crisis was simply a remake of prior episodes, going all the way back to Dutch Tulip Bulbs of 1637. While history never repeats in the same way, a different version of another crisis is only a matter of time. An average investor may be excused for thinking the stock market trend lines of the last few years will continue uninterrupted. But advisors have a fiduciary duty to ensure client portfolios are appropriately prepared for the next market “adjustment.”

Several approaches are available for protecting portfolios from a 20% or worse bear market, such as moving a notch (or two) down on the risk scale, buying protective puts, using stop-loss orders or employing more advanced strategies such as constant proportion portfolio insurance (CPPI). Assuming the well-accepted investing maxim that short of getting lucky, market timing is practically impossible, every portfolio insurance/risk reduction strategy ends up suffering from some combination of the following problems:

  1. The financial cost – whether explicit or opportunity – of implementing the strategy; and
  2. The cost associated with continual monitoring of the strategy.

Some insurance strategies entail not only a financial cost but also periodic monitoring, reversal of positions, and investing in a new tranche every few weeks or months. Lowering the risk profile of a portfolio from what is appropriate based on the investor’s degree of risk aversion will certainly insulate a portfolio somewhat from the downturn. However, the opportunity cost of missing out on a large portion of the market upswing can be substantial. Investing in a low-risk portfolio due to investors’ fear of market downturns can delay retirement because of lower returns on the portfolio.