Protect your money and investments
Protect your money and investments Image Credit: iStock

Ever seen or heard of a black swan? If not, you are not alone. It is because these creatures are so rare, that the term ‘Black Swans’ was used to define rare catastrophic global events.

So, Black Swans by that definition are mostly unforeseen, rare, and can be created by geo-political, economic, or from other unexpected events.

While there are many scenarios, broad categories include – threats to the energy grid and critical infrastructure, bio-terrorism and pandemics.

Black Swans by are unforeseen, rare, and can be created by geo-political, economic, or from other unexpected events.

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An almost immediate repercussion to any global Black Swan event is the effect it has on stock markets.

The same panic that such events create among people worldwide is also reflected in in the minds of investors and in turn their investment decisions.

What mostly follows is unprecedented levels of selling or buying when trading any asset, be it stocks, commodities, real estate or bonds.

What is an economic bubble?
An economic bubble exists when the price of an asset (e.g. stocks, real estate, bonds, or commodities) rises rapidly, then dissipates.

Bubbles happen when prices are justified by the over exuberant behavior of traders rather than the asset itself.

When there are no more traders willing to pay the overinflated price, people panic and sell and the bubble bursts, leading to a Black Swan event.

Black Swan events can have both positive and negative results, especially in financial markets. Examples of positive Black Swans include the arrival of the internet and the rise of personal computers.

Here are a few quick references to the ‘Black Swans’ or economic bubbles. The dot-com bubble, also referred to as the Internet bubble, began in April 1997 and ended in June 2003.

Instances of positive Black Swans include the arrival of the internet and the rise of personal computers.

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During the dot-com bubble, traders pumped money into newly launched Internet firms in the hopes that these startups would be worth millions. Sadly, many of these were wildly unprofitable and most of them ended up collapsing.

The September 11, 2001, terrorist attacks on the World Trade Center and the Pentagon can be categorized as Black Swan events as they were sudden and unexpected.

The New York Stock Exchange and the Nasdaq exchange did not open for trading on the morning of the attacks and remained closed until September 17 – the longest shutdown since the Great Depression.

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The south tower collapses as smoke billows from both towers of the World Trade Center, in New York, in this Sept. 11, 2001, file photo. The Port Authority of New York and New Jersey released 2,000 pages of transcripts from emergency calls and radio transmissions in New York, Thursday, Aug. 28, 2003, that provide a fierce first glimpse behind the scenes in the moments after the deadliest terrorist attack in U.S. history. (AP Photo/Jim Collins, File) Image Credit: AP

Another example of a Black Swan event is the global financial crisis of 2008.

The crisis began in the mid-2000s when US banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market.

In 2006, home prices tumbled, triggering defaults and sending out huge ripples that greatly crippled the financial industry both in the US and around the world.

Another example of a Black Swan event is the global financial crisis of 2008.

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To know in depth what led to the 2008 crisis, also read this following story on derivatives.

Several analysts on Wall Street believe that the novel coronavirus (Covid-19) pandemic is the Black Swan of 2020.

The flu-like virus, first identified in the central Chinese city of Wuhan, in December 2019, has infected tens of thousands of people and killed several thousand.

Covid-19 has wreaked havoc on the global economy, causing financial-market routs not witnessed since the 2008 global financial crisis and raising concerns that the global economy is heading towards a recession.

Pandemic
An epidemic is declared when a disease - usually infectious - spreads in a particular region. The term pandemic applies when it spreads at a global level, affecting at least two continents. The WHO dubbed the COVID-19 outbreak a pandemic on March 11. Image Credit: Pixabay

How to trade during a Black Swan event

As earlier mentioned, Black Swans are unpredictable. When they happen, they often take us by surprise and have major effects as a result.

But since these events will always be a reality, a frequent suggestion made by financial planners is to hedge your portfolio during a negative black swan event.

Black Swans are unpredictable. When they happen, they often take us by surprise and have major effects as a result.

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• Hedging your portfolio

As an investor you do know that any investment portfolio is vulnerable to a range of different risks.

No one knows for sure if, or when, there may be a market crash coming, but we can reduce risk with portfolio hedging and diversification.

To read more about diversification, also read this story on portfolio diversification.

One of the best ways to protect your investments when a negative Black Swan hits the market is by hedging your portfolio.

Hedging helps shield your investments from Black Swans
Hedging is a strategy designed to minimize the risk of adverse price changes for a given financial instrument.

Whether you are picking individual stocks or ETF investing, you can use a variety of hedging strategies to reduce downside risk, as well as other risks.

For example, if you wanted to hedge a short stock position you could purchase a call option on that stock.

To read more about ETF investing, call or put options, also read the following story.

If your equity portfolio is well-diversified and you strongly believe that the stock market will sink anywhere from 4 to 7 per cent over the next four months, a hedging strategy that costs less than 4 per cent could be worth considering.

In many cases a hedge is an instrument or strategy that appreciates in value when your portfolio loses value. The profit on the hedge therefore offsets some or all of the losses to the portfolio.

Portfolio
A well-balanced portfolio is one that is wisely diversified Image Credit: Gulf News

There are several different risks that can be hedged. Moreover, there are numerous strategies to hedge these risks. In this article we are focusing on hedging stock portfolios against volatility and loss of capital.

However, portfolio hedging can also be used to hedge against other risks including inflation, currency risk, interest rate risk and duration risk.

An advice against buying too many cheap stocks during Black Swan events
Some Black Swan events may cause bear markets that give traders a great opportunity to buy stocks that are in a free fall.

While this represents tremendous opportunities to make money, it is not always good to go on a stock-buying spree as you could end up losing everything if the market crashes.

It also makes sense to take your money out of the stock market if you think there is a higher chance of a substantial move to the downside, even if it means that you have an equal chance of missing a huge gain.

How portfolio hedging works

You can implement a hedge to protect an individual security. However, if individual securities carry risk, it makes more sense to reduce or close the position.

Investors typically want to protect their entire stock portfolio from market risk rather than specific risks. Therefore, you would hedge at the portfolio level, usually by using an instrument related to a market index.

If individual securities carry risk, it makes more sense to reduce or close the position.

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You can implement a hedge by buying another asset, or by short selling an asset. Purchasing an asset like an option, transfers the risk to another party. Short selling is a more direct form of executing a hedge.

To learn more about short-selling, also read the following story on short-selling.

Hedges are very seldom perfect, and if they were, they would serve no real function as there would be no potential for upside or for downside. In many cases only part of the portfolio will be hedged.

The goal is to reduce risk to an acceptable level, rather than removing it.

How can one go about investing in exchange-traded fund (ETF)?
Image Credit: Shutterstock

To know of ways to hedge a stock portfolio, also read this following article on trading amid volatility.

Buying products with inverse returns

Buying products with inverse returns is a relatively new method of hedging stocks. You can now buy ETFs and other securities that appreciate in price when the broad stock market loses money.

Some of these instruments are leveraged, which requires less capital for a hedge to be implemented.

However, some of these inverse-return instruments are leveraged, which requires less capital for a hedge to be implemented.

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The advantage of these securities is that they can be traded in an ordinary stock trading account, without the need for a futures or options account.

To know more about leverage and how it works, also read the following story on leverage and margin trading.

However, before using them, they should be carefully vetted to ensure they inversely track the underlying security closely.

Buying volatility

Buying volatility is another way to hedge equities that has become available recently.

For instance, the VIX index is an index measure of volatility on the US stock markets. There is an active market for futures based on the VIX index, and there are also ETFs and options based on these futures.

Buying volatility is another way to hedge equities that has become available recently.

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Because volatility typically rises during market corrections, these instruments gain value when a long position in equities loses value.

Buying volatility ETFs when the VIX is at historically low levels is an effective method of hedging. It should be noted that volatility products do typically lose value over time.

Now let’s run through the key risks that an investor is faced with when hedging.

Key risks to hedging

• Hedging involves cost that can eat up the profit.

• Risk and reward are often proportional to one other; thus reducing risk means reducing profits.

• For most short-term traders, e.g.: for a day trader, hedging is a difficult strategy to follow.

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To read more about how day, swing or short trading works, also read the following story.

• If the market is performing well or moving sidewise, then hedging offer little benefits.

• Trading of options or futures often demand higher account requirements like more capital or balance.

• Hedging is a precise trading strategy and successful hedging requires good trading skills and experience.

Some safe haven investments against Black Swans

Cutting equity exposure and increasing allocations to alternatives is one way an investor could go about it.

Investment schemes or funds are both investing more in alternatives and investing in a broader range of asset classes that are less traditional.

Cutting equity exposure and increasing allocations to alternatives is one way an investor could go about it.

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One of the most popular is emerging market debt, but new asset classes such as private debt, which would not have been included in portfolios five to ten years ago, are also attracting investment from such funds.

Small to medium-sized enterprises have traditionally accessed finance through banks, but banks are moving away from that space at these times.

Funds and other investors who are willing to step in can achieve quite attractive rates of return, matter experts add.

Some newer alternatives are trending!
Other newer alternatives include infrastructure projects such as public-private partnerships and high-income property mandates such as ground lease mandates. For example, such trends are seen in UK now.

(Ground lease mandates are agreements seen in most countries in which a tenant is permitted to develop a piece of property during the lease period).

Advisors are now often seeing there’s quite a lot of illiquidity in ground lease mandates, but as an alternative to corporate bonds – if investors can accept that illiquidity – they are often attractive.

Also investment schemes are seen moving away from accessing hedge funds through funds of funds and instead accessing hedge funds directly, thereby cutting out a layer of fees.

Approaches to the bond portion of the portfolio have also changed.

With developed-world sovereign bonds not providing the safe haven they once did, investment schemes typically invest in a wider range of bonds.

They also need to get more from their bond investments to compensate for low-growth on the equity side.

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Bonds Image Credit: File photo

But responding to the “new normal” is not just about asset allocation choices; it is also about being ready and willing to rotate assets.

This demands a different, more engaged approach from fund trustees, or, to put it another way - You need to think about what you can’t see coming. You need to be able to move quickly out of asset classes if they become over-valued.

Responding to the “new normal” is not just about asset allocation choices; it is also about being ready and willing to rotate assets.

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To achieve this, trustee groups need to meet more often and be proactive. Sometimes they are prepared to do this, and sometimes they are not.

Those that are not may employ a manager who can take a rotational approach to different assets.

Safe-haven stocks?

For investors looking to insulate their portfolios from the additional COVID-19 downside, there is evidence to suggest that gold acts as both a hedge and a safe haven for equity markets over recent years, and particularly during crises periods.

The outbreak just drives home the lesson that gold and silver are the best safe havens.

Making sure one has significant savings in gold and silver always makes sense, adds professional investors, and if they were to speculate based on the outbreak, they would buy more of the best gold and silver stocks.

Going to cash for now too makes a lot of sense to veteran investors. It’s hard to go broke accumulating cash.

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