Author Topic: Black Swans and Index Investing  (Read 13474 times)

randersonnw

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Black Swans and Index Investing
« on: November 19, 2014, 12:43:55 AM »
I searched the forum for Nassim Nicholas Taleb and Black Swan. There has been no discussion. I would love MMM's' take (and the MMM community) on this nuanced and broad topic. If most of your income is tied to an index fund and there is a big dip you may need to sell when the market is low to have income. If your relying on dividend index fund, you get paid cash per share so maybe not. Of course there are many factors and nuances, but I thought this would be a neat discussion topic for a community like this. Thank you. First post from a reader of the last couple years, hope to have FI in 6-7 years. I look forward to meeting you all.

surfhb

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Re: Black Swans and Index Investing
« Reply #1 on: November 19, 2014, 02:22:54 AM »
This is where asset allocation come in.    The market will most likely take a 50% dump from where we are now.    You need to be comfortable with those kind of market fluctuation.   If not, you're not prepared for retirement

Malaysia41

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Re: Black Swans and Index Investing
« Reply #2 on: November 19, 2014, 02:55:26 AM »
It's as simple as having enough cash to get you through the black swan event.

... and just that difficult; sitting on cash when the market is moving up takes fortitude. 

And of course, diversification across asset classes.

waltworks

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Re: Black Swans and Index Investing
« Reply #3 on: November 19, 2014, 08:16:23 AM »
No discussion? Hah!

Shit happens. Expect it. Diversify and be badass. Done. Been talked about probably a thousand times here.

-W

milesdividendmd

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Black Swans and Index Investing
« Reply #4 on: November 19, 2014, 11:49:35 AM »
I too love Taleb, but Index investing really has nothing to do with black swan avoidance.

You can decrease exposure to fat tails (good and bad) by investing in 70 % treasury indices and 30% high risk, high reward equities (domestic and international small cap value, and EM value. )

Larry Swedroe has written volumes on this barbelling technique (which Taleb has also written about in "anti fragility.")
« Last Edit: November 19, 2014, 03:43:03 PM by milesdividendmd »

hodedofome

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Re: Black Swans and Index Investing
« Reply #5 on: November 19, 2014, 01:38:28 PM »
80% AGG Bond Fund and 20% XIV. Rebalanced annually. There you go.

index

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Re: Black Swans and Index Investing
« Reply #6 on: November 20, 2014, 08:07:25 PM »
80% AGG Bond Fund and 20% XIV. Rebalanced annually. There you go.

What about a black swan in bonds?

hodedofome

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Re: Black Swans and Index Investing
« Reply #7 on: November 20, 2014, 09:31:05 PM »
Well hopefully that'll be combined with contango in VIX futures! But in reality, even when interest rates went to 15% in the 80s, on an annual basis AGG bonds didn't lose much. It's interesting to consider the risks for a portfolio like this however.

It doesn't mean anything, but the past 10 years this strategy would have returned almost 15% a year. Using TLT instead, that jumps to 30%.

Primm

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Re: Black Swans and Index Investing
« Reply #8 on: November 20, 2014, 10:03:29 PM »
The thing with black swans is that by definition they are an event that is not only unpredictable but believed not to exist. Therefore you can't prepare for them. I like waltworks' quote:

 

Shit happens. Expect it. Diversify and be badass. Done. Been talked about probably a thousand times here.

-W

index

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Re: Black Swans and Index Investing
« Reply #9 on: November 20, 2014, 10:24:58 PM »
Well hopefully that'll be combined with contango in VIX futures! But in reality, even when interest rates went to 15% in the 80s, on an annual basis AGG bonds didn't lose much. It's interesting to consider the risks for a portfolio like this however.

It doesn't mean anything, but the past 10 years this strategy would have returned almost 15% a year. Using TLT instead, that jumps to 30%.

Backtesting after a secular bull market in bonds means nothing, which you acknowledged. If interest rates turn hard, agg will erode in value. Xiv, while helped by contango only deals with options contracts two months out which are not affected by interest rates to the same degree as liner termed bonds. In addition, a blue up in bonds will affect spy volatility forcing xiv down. Unless you believe we are headed for deflation, your strategy doesn't hold water.

Primm, diversify and be bad ass yes, but so many people here hate debt. Debt is something to hold with diversity. Cheap subsidized mortgage debt locked in at ridiculous rates should be viewed as an asset class as well. Very few understand this.

Primm

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Re: Black Swans and Index Investing
« Reply #10 on: November 20, 2014, 10:52:20 PM »
Primm, diversify and be bad ass yes, but so many people here hate debt. Debt is something to hold with diversity. Cheap subsidized mortgage debt locked in at ridiculous rates should be viewed as an asset class as well. Very few understand this.

Oh, I do! My mortgage is at ridiculously low rates and my student loans are indexed at CPI. Ain't no way I'm paying off those bad boys in a hurry. I have a credit card at 3.99% for life as well, and as soon as I can work out how to buy shares with it without it counting as a cash advance I'm loading that up too. :)

dungoofed

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Re: Black Swans and Index Investing
« Reply #11 on: November 21, 2014, 03:41:51 AM »
The thing with black swans is that by definition they are an event that is not only unpredictable but believed not to exist. Therefore you can't prepare for them.

Could it be argued that gold is the "almighty black swan defense"?

I'm trying to think of Black Swan events that would send gold tumbling. Bringing a massive meteor made of gold to earth? A technological advance so fantastic that productivity just goes through the roof and stocks increase 10-fold per year, every year? Population explosion?


index

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Re: Black Swans and Index Investing
« Reply #12 on: November 21, 2014, 07:03:34 AM »
The thing with black swans is that by definition they are an event that is not only unpredictable but believed not to exist. Therefore you can't prepare for them.

Could it be argued that gold is the "almighty black swan defense"?

I'm trying to think of Black Swan events that would send gold tumbling. Bringing a massive meteor made of gold to earth? A technological advance so fantastic that productivity just goes through the roof and stocks increase 10-fold per year, every year? Population explosion?

Deflation.

Gold is a pretty metal, but it produces nothing and it's not an "investment". People point to the collapse of fiat currency and governments as a reason to hold gold. If this happens someone can just take it from you. Gold bullion is just another currency with obscenely high transaction and storage costs.

milesdividendmd

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Black Swans and Index Investing
« Reply #13 on: November 21, 2014, 11:47:07 AM »
In Taleb's excellent book anti-fragility, he points out that predicting Blackswan events is futile.

The conclusion is not a "throw up your hands, there's nothing you can do" sort of a conclusion however.

His thesis is that although predicting a future events is impossible, predicting one's vulnerability to randomness is not.

As an example a 100% stock portfolio is vulnerable to anything that causes a collapse of stocks: hyperinflation, deflation, government seizure, flash crashes, etc. in this sense a 100% stock portfolio is "fragile."

So the only outcome in which 100% stock portfolio wins long term, is if stocks win long term.

A well diversified portfolio, say a permanent portfolio with 25% stocks, 25% long-term treasuries, 25% gold, and 25% cash is much more "robust" to black swan events. it is largely unaffected by them.

And of course options can be benefited by Blackswan events. So options can be an example of an anti-fragile investment strategy. (One that benefits from randomness.)

index

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Re: Black Swans and Index Investing
« Reply #14 on: November 21, 2014, 01:15:52 PM »
In Taleb's excellent book anti-fragility, he points out that predicting Blackswan events is futile.

The conclusion is not a "throw up your hands, there's nothing you can do" sort of a conclusion however.

His thesis is that although predicting a future events is impossible, predicting one's vulnerability to randomness is not.

As an example a 100% stock portfolio is vulnerable to anything that causes a collapse of stocks: hyperinflation, deflation, government seizure, flash crashes, etc. in this sense a 100% stock portfolio is "fragile."

So the only outcome in which 100% stock portfolio wins long term, is if stocks win long term.

A well diversified portfolio, say a permanent portfolio with 25% stocks, 25% long-term treasuries, 25% gold, and 25% cash is much more "robust" to black swan events. it is largely unaffected by them.

And of course options can be benefited by Blackswan events. So options can be an example of an anti-fragile investment strategy. (One that benefits from randomness.)

I agree with you on the well diversified portfolio. Though I would switch gold with mortgage debt.

Options are truly the best way to protect from these type of events. Deep in the money leaps or long dated options and holding the remainder of the position in cash is much more robust than holding the underlying. 

IE- Instead of buying 100 shares of SPY at 206.50 today for 20,650; you buy 1 December '16 option with a $150 strike for $5825 and hold $14825 in cash (or a savings account yielding 1%).

Spy at $230 in December '15 (~10% gain):

100 Shares of SPY - 23k - gain of $2350
Option would be at approximately $8000 - gain of $2175, ~15k @ 1% gained $150 for a total gain of $2325

SPY at $160 in December '15 (~20% decline - Normal Correction):

100 Shares of SPY - 16k - loss of 4650 (-22.5%)
Option would be at ~1800 (intrinsic and tv) loss of $4025 and a gain of $150 on 15k @ 1% - total loss of $3875 (-18.7%)

Spy at 120 in December '15 (~40% decline - Black Swan)

100 Shares of SPY - 12K - Loss of $8650 (42%)
Option would be at $200 and 15k at 1% would earn $150 - Total loss of $5475 (26.5%)

hodedofome

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Re: Black Swans and Index Investing
« Reply #15 on: November 21, 2014, 02:44:29 PM »
Backtesting after a secular bull market in bonds means nothing, which you acknowledged. If interest rates turn hard, agg will erode in value. Xiv, while helped by contango only deals with options contracts two months out which are not affected by interest rates to the same degree as liner termed bonds. In addition, a blue up in bonds will affect spy volatility forcing xiv down. Unless you believe we are headed for deflation, your strategy doesn't hold water.

Primm, diversify and be bad ass yes, but so many people here hate debt. Debt is something to hold with diversity. Cheap subsidized mortgage debt locked in at ridiculous rates should be viewed as an asset class as well. Very few understand this.

I'd never hold a portfolio of XIV and AGG without having tested it since the '70s. Because we don't have VIX futures and therefore VXX/XIV data going back that far, I'd be hesitant to expect it to hold up in various environments. However, it's interesting to come up with a portfolio that takes advantage of the persistant contango in VIX futures (XIV or short VXX if you can find the shares) as well as a suitable hedge for volatile environments. I've though of XIV and bonds, but then if you had a stagflation + volatile environment that could hurt. I've been working on XIV + SPY puts but I haven't come up with a workable scenario yet.

Tyler

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Re: Black Swans and Index Investing
« Reply #16 on: November 21, 2014, 02:54:49 PM »
In Taleb's excellent book anti-fragility, he points out that predicting Blackswan events is futile.

The conclusion is not a "throw up your hands, there's nothing you can do" sort of a conclusion however.

His thesis is that although predicting a future events is impossible, predicting one's vulnerability to randomness is not.

As an example a 100% stock portfolio is vulnerable to anything that causes a collapse of stocks: hyperinflation, deflation, government seizure, flash crashes, etc. in this sense a 100% stock portfolio is "fragile."

So the only outcome in which 100% stock portfolio wins long term, is if stocks win long term.

A well diversified portfolio, say a permanent portfolio with 25% stocks, 25% long-term treasuries, 25% gold, and 25% cash is much more "robust" to black swan events. it is largely unaffected by them.

And of course options can be benefited by Blackswan events. So options can be an example of an anti-fragile investment strategy. (One that benefits from randomness.)

+1

Very good explanation. 

KingCoin

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Re: Black Swans and Index Investing
« Reply #17 on: November 21, 2014, 04:59:49 PM »
In Taleb's excellent book anti-fragility, he points out that predicting Blackswan events is futile.

The conclusion is not a "throw up your hands, there's nothing you can do" sort of a conclusion however.

His thesis is that although predicting a future events is impossible, predicting one's vulnerability to randomness is not.

As an example a 100% stock portfolio is vulnerable to anything that causes a collapse of stocks: hyperinflation, deflation, government seizure, flash crashes, etc. in this sense a 100% stock portfolio is "fragile."

So the only outcome in which 100% stock portfolio wins long term, is if stocks win long term.

A well diversified portfolio, say a permanent portfolio with 25% stocks, 25% long-term treasuries, 25% gold, and 25% cash is much more "robust" to black swan events. it is largely unaffected by them.

And of course options can be benefited by Blackswan events. So options can be an example of an anti-fragile investment strategy. (One that benefits from randomness.)

+1

Very good explanation.

While something like the permanent portfolio is perhaps more robust than a stock heavy portfolio, it's also likely to barely keep up with inflation. You're free to buy downside puts, but they're expensive (despite Taleb's claims to the contrary, the market is wise to "fat tails"), and they'll sap your returns considerably. It comes back to a simple risk/reward equation. The nice thing about most black swan events is that they're temporary.

KingCoin

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Re: Black Swans and Index Investing
« Reply #18 on: November 21, 2014, 05:04:53 PM »
Also, there's no difference in the return profile of a portfolio of companies that pay a cash dividend on a market dip vs a portfolio of companies that instead use earnings to buy back stock (which you sell to raise funds). The only difference is that in the former situation you'll owe taxes while the later will likely give you a tax break.

So many investors (even in this forum) think there's something magic about companies that pay dividends. There's not.

Tyler

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Re: Black Swans and Index Investing
« Reply #19 on: November 21, 2014, 05:36:32 PM »
While something like the permanent portfolio is perhaps more robust than a stock heavy portfolio, it's also likely to barely keep up with inflation.

This isn't really the thread to debate specific portfolios, but the Permanent Portfolio has outpaced inflation by 3-7% annually over every rolling 10-year period in its history (something the stock market has certainly not done).  Consistently beating inflation is one of the things it's quite good at.

No matter how you choose to diversify, the key point is that it takes more than index investing in stocks to mitigate Black Swans in the stock market.  Asset allocation and diversification make a big difference.  Milesdividendmd has mentioned several good options in this thread.
« Last Edit: November 21, 2014, 05:40:16 PM by Tyler »

KingCoin

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Re: Black Swans and Index Investing
« Reply #20 on: November 21, 2014, 05:37:46 PM »
While something like the permanent portfolio is perhaps more robust than a stock heavy portfolio, it's also likely to barely keep up with inflation.

This isn't really the thread to debate specific portfolios, but the Permanent Portfolio has outpaced inflation by 3-7% annually over every rolling 10-year period in its history (something the stock market has certainly not done).  Consistently beating inflation is one of the things it's quite good at. 

No matter how you choose to diversify, the key point is that it takes more than index investing in stocks to mitigate Black Swans in the stock market.  Asset allocation and diversification make a big difference.  Milesdividendmd has mentioned several good options in this thread.

I'll argue that this time is different. Just add up the numbers:

Gold = Inflation
Cash = Inflation-2%
Gov Bonds = Inflation+1.5%
Stock = Inflation+6%

That averages to Inflation+1.375%. Maybe you do a little better if rebalancing works in your favor.

The bond and gold markets have gone on historic bull runs that aren't really repeatable and which makes back-tests over the last 30yrs look excessively rosy in my opinion.

In any event, I think the permanent portfolio is probably fine if you're looking to be extremely defensive, and I'll certainly agree with your point about the importance of diversification.

Tyler

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Re: Black Swans and Index Investing
« Reply #21 on: November 21, 2014, 05:55:17 PM »
I'm sure a lot of stock investors in the 70's and 00's would chuckle at the "Stock=inflation+6%" simplification.  ;)

Asset allocation involves a lot more than averaging the lifetime returns of each asset.  Just like SWR discussions, order of returns and timeframe matters.  Whether or not one believes it is the best choice for their own money, I'd argue that the Permanent Portfolio results speak for themselves. 

All that said, we're certainly on the same page when it comes to diversifiction (and dividends, BTW).

KingCoin

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Re: Black Swans and Index Investing
« Reply #22 on: November 21, 2014, 06:11:05 PM »
I'm sure a lot of stock investors in the 70's and 00's would chuckle at the "Stock=inflation+6%" simplification.  ;)

Asset allocation involves a lot more than averaging the lifetime returns of each asset.  Just like SWR discussions, order of returns and timeframe matters.  Whether or not one believes it is the best choice for their own money, I'd argue that the Permanent Portfolio results speak for themselves. 

All that said, we're certainly on the same page when it comes to diversifiction (and dividends, BTW).

I agree. Some inter-asset volatility has the potential to juice returns. However, that doesn't negate the fact that 75% of the PP has essentially 0 real returns in the current market regime. 30yrs ago, when 30yr treasuries yielded 12%, bonds at least had some real upside. At a 3% yield, that asset class is looking pretty negatively convex.

Maybe we start looking like Japan and the PP continues to work its magic vs more traditional allocations. Maybe it doesn't. It's up to each investor to decide what they want their portfolio to look like. This is just one case where I think "backtesting" can be misleading. The last 30 years have been basically tailor made for the PP. The next 30 years might not be.

milesdividendmd

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Re: Black Swans and Index Investing
« Reply #23 on: November 21, 2014, 06:34:28 PM »

In Taleb's excellent book anti-fragility, he points out that predicting Blackswan events is futile.

The conclusion is not a "throw up your hands, there's nothing you can do" sort of a conclusion however.

His thesis is that although predicting a future events is impossible, predicting one's vulnerability to randomness is not.

As an example a 100% stock portfolio is vulnerable to anything that causes a collapse of stocks: hyperinflation, deflation, government seizure, flash crashes, etc. in this sense a 100% stock portfolio is "fragile."

So the only outcome in which 100% stock portfolio wins long term, is if stocks win long term.

A well diversified portfolio, say a permanent portfolio with 25% stocks, 25% long-term treasuries, 25% gold, and 25% cash is much more "robust" to black swan events. it is largely unaffected by them.

And of course options can be benefited by Blackswan events. So options can be an example of an anti-fragile investment strategy. (One that benefits from randomness.)

+1

Very good explanation.

While something like the permanent portfolio is perhaps more robust than a stock heavy portfolio, it's also likely to barely keep up with inflation. You're free to buy downside puts, but they're expensive (despite Taleb's claims to the contrary, the market is wise to "fat tails"), and they'll sap your returns considerably. It comes back to a simple risk/reward equation. The nice thing about most black swan events is that they're temporary.

I don't invest in the permanent portfolio personally, but your criticism of it is off the mark.

The permanent portfolio has done much better than "barely keep up with inflation."

See here

http://www.crawlingroad.com/blog/2008/12/22/permanent-portfolio-historical-returns/

And

http://assetbuilder.com/andrew_hallam/the_worlds_best_investment_strategy_that_nobody_seems_to_like

And the statement that "most" black swans are temporary, is exactly the point that you are missing. Black swans are by definition low frequency, unpredictable  events, so a permanent or multi decade  loss of capital in the stock market would qualify as a black swan. The fact that such events usually never happen is cold comfort if/when it does happen.

And it is clear that a 100 % stock portfolio is fragile to such a rare event. Whereas a permanent portfolio is not.


milesdividendmd

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Re: Black Swans and Index Investing
« Reply #24 on: November 21, 2014, 08:00:24 PM »

While something like the permanent portfolio is perhaps more robust than a stock heavy portfolio, it's also likely to barely keep up with inflation.

This isn't really the thread to debate specific portfolios, but the Permanent Portfolio has outpaced inflation by 3-7% annually over every rolling 10-year period in its history (something the stock market has certainly not done).  Consistently beating inflation is one of the things it's quite good at. 

No matter how you choose to diversify, the key point is that it takes more than index investing in stocks to mitigate Black Swans in the stock market.  Asset allocation and diversification make a big difference.  Milesdividendmd has mentioned several good options in this thread.

I'll argue that this time is different. Just add up the numbers:

Gold = Inflation
Cash = Inflation-2%
Gov Bonds = Inflation+1.5%
Stock = Inflation+6%

That averages to Inflation+1.375%. Maybe you do a little better if rebalancing works in your favor.

The bond and gold markets have gone on historic bull runs that aren't really repeatable and which makes back-tests over the last 30yrs look excessively rosy in my opinion.

In any event, I think the permanent portfolio is probably fine if you're looking to be extremely defensive, and I'll certainly agree with your point about the importance of diversification.

You are arguing both that you know which way the bond and gold markets will move and that "this time it is different."

In general these are not very wise arguments to make.

The whole point that Taleb makes very well is that prediction is a suckers game but that "fragility," "robustness" and "anti fragility" in investment (and many other arenas) are recognizable a priori.

milesdividendmd

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Re: Black Swans and Index Investing
« Reply #25 on: November 21, 2014, 08:06:34 PM »
Also, the claim that gold equals inflation is demonstratably false since we came off of the gold standard 44 years ago.


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Re: Black Swans and Index Investing
« Reply #26 on: November 21, 2014, 08:49:09 PM »
The problem with the permanent portfolio is we have had a 40 year secular bull market in bonds. If you are in the deflation camp ala Japan then by all means use the permanent portfolio.

Also puts need not be the only options purchased to hedge far trail risk. Ditm calls, outlined in my last post, are cheap ~0.1% (you may have to sell calls to make up for dividends).

I use Ditm bear call spreads to hedge personally.  Most of the time they expire worthless but they pay 8-12:1 when the underlying security falls below the spread. 

milesdividendmd

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Re: Black Swans and Index Investing
« Reply #27 on: November 21, 2014, 10:40:25 PM »

The problem with the permanent portfolio is we have had a 40 year secular bull market in bonds. If you are in the deflation camp ala Japan then by all means use the permanent portfolio.

Also puts need not be the only options purchased to hedge far trail risk. Ditm calls, outlined in my last post, are cheap ~0.1% (you may have to sell calls to make up for dividends).

I use Ditm bear call spreads to hedge personally.  Most of the time they expire worthless but they pay 8-12:1 when the underlying security falls below the spread.

It's not accurate to say that we've come off of a 40 year secular bull market in bonds, unless you are making the claim that from 1974 until 1982 we were in a bull market for bonds during that period of high inflation.

(During this time period long-term bonds underperformed cash/short-term bonds by almost 3%. And a -3% real return is not bullish by any rational measure.)

When it comes to prediction, I am not in any camp at all. I am totally agnostic.  Bond Yields could continue to drop, or they could spike, either is possible, and neither is knowable. But judging one's portfolio's susceptibility to such scenarios is knowable. So it seems axiomatic that this is where we should focus our attention.

Your use of options is one such approach to this challenge.

I favor using market timing with dual momentum, which is quite "anti- fragile," in that it beats the market most dramatically during severe Bear markets.

http://www.milesdividendmd.com/jumping-off-a-cliff/

I am not advocating this approach for anybody else.  I am merely admitting that this is my approach.  And the factor that most drew me to this approach was its strength during bear markets.

The most obvious approach to mitigating Black swan risk is aggressive Buy and hold diversification, as in the permanent portfolio.


hodedofome

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Re: Black Swans and Index Investing
« Reply #28 on: November 22, 2014, 06:22:01 AM »
I personally use a form of Antonnacci's dual momentum in my retirement and trading accounts as well. It's how I've decided to manage tail risk.

Tyler

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Re: Black Swans and Index Investing
« Reply #29 on: November 22, 2014, 12:57:52 PM »
Another angle to Black Swan protection to think about in investing are things like counter-party risk and institutional diversification. 

For example, even when you are well diversified in your investments, if you own your investments all through iShares then your entire portfolio is exposed to counter-party risk if Blackrock ever has financial issues or mismanages your funds (read the fine print -- companies very often lend out shares even within passive index funds to goose returns and include clauses to limit their liability if a deal goes south).  Similarly, if you diversify index companies with people like State Street (SPDR), Vanguard, etc. but hold all of them in a single brokerage account, you are susceptible to any unexpected issues with that brokerage.  For example, someone stealing your password and having immediate access to all your savings in one place and it taking months or years to sort out is not at all unheard of. 

Protecting against Black Swans means not simply protecting yourself against large market swoons, but also smaller events that can just as easily wipe you out.  As a general rule, never put all your eggs in a single basket. 
« Last Edit: November 22, 2014, 01:02:39 PM by Tyler »

KingCoin

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Re: Black Swans and Index Investing
« Reply #30 on: November 22, 2014, 01:58:48 PM »

I don't invest in the permanent portfolio personally, but your criticism of it is off the mark.

The permanent portfolio has done much better than "barely keep up with inflation."


Yes, it's outperformed inflation in the past. But that's with bond yields going from 14% to 3%. At least with respect to bonds, I do know that "this time is different" due to the near 0% bound in bond yields. Bond yields aren't going to -11% over the next 30 years. The claim that gold will perform at the rate of inflation is over the long term. There will obviously be periods of outperformance and underperformcne. Gold can't outperform inflation over the long term or it would eventually be infinitely valuable. Coming off the gold standard is irrelevant to the long term performance of this asset class. So yes, I can make fairly definite claims about gold too.

Stocks could suck for the next 20 years, no doubt. Nowhere did I argue that anyone should be in a 100% stock portfolio.

Right now cash is earning nothing, the long bond has a de minimus yield, and gold is a lump of metal. A portfolio that's 75% in these assets is mighty bearish (though that hasn't always been true). As I stated before, it could work out, and I'm not arguing that it's not a viable asset allocation. It's just much less attractive than it was 30 years ago. It will probably be rewarding in the long term to diversify across assets with a real return. That might include investments as diverse as real estate, stocks, timberland assets, and mezzanine tranche CLO's. Of course, something like 60% stocks, 20% bonds, 20% REITs is probably just fine too.

milesdividendmd

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Black Swans and Index Investing
« Reply #31 on: November 22, 2014, 03:50:49 PM »
Your argument about inflation is misguided. Compared to your suggested 60/20/20 portfolio, the permanent portfolio is only 5% more heavy in bonds. Hardly a difference at all.

Furthermore, one need only look back to our last period of hyperinflation, from 1973 to 1982 to see exactly how the permanent portfolio performs in hyperinflationary environments.

The answer is that the permanent portfolio performed quite well, to the tune of a CAGR of 12.74%, with a max drawdown of 5.17%. (this is actually a better performance than its long-term performance including non-inflationary periods.)

 While nominal bond yields cannot go to -11, the real return can remain steady going forward as in the case of deflation.

Your argument about gold not being able to outpace inflation is utter nonsense, as the exact same argument could be made about any asset class going to infinite value, including equities.

Value is determined by supply and demand in gold as in all assets.

The importance of coming off of the gold standard is that prior to this development, the dollar was inseparably tied to the value of gold, So owning 25% gold and 25% cash would be like owning 50% cash.
« Last Edit: November 22, 2014, 03:56:09 PM by milesdividendmd »

KingCoin

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Re: Black Swans and Index Investing
« Reply #32 on: November 23, 2014, 08:09:04 AM »
Your argument about inflation is misguided. Compared to your suggested 60/20/20 portfolio, the permanent portfolio is only 5% more heavy in bonds. Hardly a difference at all.

The obvious difference is the massive allocation to cash and gold.

Furthermore, one need only look back to our last period of hyperinflation, from 1973 to 1982 to see exactly how the permanent portfolio performs in hyperinflationary environments.

The answer is that the permanent portfolio performed quite well, to the tune of a CAGR of 12.74%, with a max drawdown of 5.17%. (this is actually a better performance than its long-term performance including non-inflationary periods.)

I used inflation as a floating variable for good reason. I'd also add that going into 1973, interest rates were far higher than they are now, so some inflation was already priced into the markets. Not-so now. I personally don't have much of a view.

While nominal bond yields cannot go to -11, the real return can remain steady going forward as in the case of deflation.

Correct, which is the only reason one could really justify owning 30yr treasuries at 3%.

Your argument about gold not being able to outpace inflation is utter nonsense, as the exact same argument could be made about any asset class going to infinite value, including equities.

Value is determined by supply and demand in gold as in all assets.

Incorrect. Assets with real returns (like equities, bonds, and real estate) issue distributions which keep their face value from rising infinitely. Gold does not. Gold has been used as a currency for 3000+ years. If it had even 1% real return, it's value would be near infinite (a $1000 real value in 1000BC would equate to $9 quadrillion real value in 2000AD).


I'll say it for the third time. I don't think the PP is bad, and I'm not trying to make a case against it. I'm simply arguing that the case for it relies extremely heavily on a backtest on a 30 year time period where conditions were very favorable for the PP. If you take a look at what the portfolio holds now, and the return characteristics of each asset, it's hard to be optimistic. Maybe it just augers the fact that real returns will be more difficult to come by in the decades to come.

milesdividendmd

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Re: Black Swans and Index Investing
« Reply #33 on: November 23, 2014, 12:14:15 PM »
Just as you are not arguing against PP I am not arguing for it.

I don't own the PP, nor do I own any gold.

What I am arguing is that the PP is very well suited to avoiding being killed by black swans, and it has proven this quality over 40 (not 30) years in multiple environments.

Your arguments against it have holes, which I feel compelled to point out.

Your argument about gold is interesting but  flawed, I suspect in that up until 42 years ago gold was tied to the value of money. Now, just like other real assets like real estate (which does not have real returns any more than gold) , gold is not. It's price is tied to demand. And in the age of fiat money, as long as the monetary base continues to expand, (which does not necessarily coincide with inflation, as in our current environment) the price of gold can continue to outpace inflation.

Unfortunately We can't back test this beyond our benchmark currency having left the gold standard.

The limits of endless growth apply to all assets equally, and price growth is likely to continue to be the main driver of stock market returns going forward, as more companies buy back shares rather than pay dividends.

Also cash in the PP refers to Tbills, which should be inflation agnostic, due to their short duration and rolling yields. So the cash portion of the portfolio is neither helped not harmed by inflation. (In contrast to the long treasuries. )

The best argument against the PP is behavioral, in that it has massive tracking error and will be hard for any investor to stick to going forward.

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Re: Black Swans and Index Investing
« Reply #34 on: November 23, 2014, 12:36:15 PM »
@MDMD: All good points.

I'll only add that the same person who abandons the Permanent Portfolio when it lags the S&P will likely abandon the S&P when it lags the Permanent Portfolio. Performance chasing in investing is portfolio agnostic.  Others find that the relatively smooth ride and steady returns of the PP sans all the market swings makes it very easy to stick to. Ultimately your investing choice needs to match your personality or you'll never be happy.

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Re: Black Swans and Index Investing
« Reply #35 on: November 23, 2014, 02:00:05 PM »
When confronting a lot of the problems re: permanent portfolio vs bogleheads portfolio I came up with the 'whiskey portfolio':
50% total world stock index
25% long term treasuries
25% short term TIPS

It maintains a lot of the functionality of the individual PP components but avoids the heavy gold/cash holdings.

steveo

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Re: Black Swans and Index Investing
« Reply #36 on: November 23, 2014, 02:02:50 PM »
A well diversified portfolio, say a permanent portfolio with 25% stocks, 25% long-term treasuries, 25% gold, and 25% cash is much more "robust" to black swan events. it is largely unaffected by them.

The problem though with this approach is that your returns may be significantly less and therefore you need a significantly larger portfolio to retire on.

If the black swan event occurs every 25 years and it drops stocks by 50% and you have an 80/20 stocks/bonds portfolio you might be in the long term be better off with the standard 80/20 portfolio.

steveo

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Re: Black Swans and Index Investing
« Reply #37 on: November 23, 2014, 02:06:50 PM »
When confronting a lot of the problems re: permanent portfolio vs bogleheads portfolio I came up with the 'whiskey portfolio':
50% total world stock index
25% long term treasuries
25% short term TIPS

It maintains a lot of the functionality of the individual PP components but avoids the heavy gold/cash holdings.

I can't see myself holding that much cash equivalent investments.

I suppose that there is no perfect AA though is there. My take is own your house, invest heavily in stocks and then prior to retiring put some into other asset classes such as gold/commodities/bonds and lastly ensure you have a cash buffer.

milesdividendmd

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« Reply #38 on: November 23, 2014, 02:28:41 PM »
When confronting a lot of the problems re: permanent portfolio vs bogleheads portfolio I came up with the 'whiskey portfolio':
50% total world stock index
25% long term treasuries
25% short term TIPS

It maintains a lot of the functionality of the individual PP components but avoids the heavy gold/cash holdings.

I can't see myself holding that much cash equivalent investments.

I suppose that there is no perfect AA though is there. My take is own your house, invest heavily in stocks and then prior to retiring put some into other asset classes such as gold/commodities/bonds and lastly ensure you have a cash buffer.

I actually agree with this.  Long term one would expect higher returns with an 80/20 portfolio.

But the more, black swans, bear markets and market stressors, the better the PP will do in comparison to a stock heavy portfolio.

In this way, such an aggressively diversified approach is "anti fragile."
« Last Edit: November 23, 2014, 03:02:50 PM by milesdividendmd »

KingCoin

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Re: Black Swans and Index Investing
« Reply #39 on: November 23, 2014, 08:46:29 PM »
Your argument about gold is interesting but  flawed, I suspect in that up until 42 years ago gold was tied to the value of money. Now, just like other real assets like real estate (which does not have real returns any more than gold) , gold is not. It's price is tied to demand. And in the age of fiat money, as long as the monetary base continues to expand, (which does not necessarily coincide with inflation, as in our current environment) the price of gold can continue to outpace inflation.

This sort of made my head explode. Real estate doesn't have real returns? What?!

Like gold, real estate's value will rise over time with inflation. Unlike gold it will also produce a gusher of a cash stream in the form of rental income (even after taxes, maintenance, and other related expenses, real estate should deliver 4-9% return on top of price appreciation). There's a reason a lot of people get rich investing in real estate (even on an unlevered basis) and not many get rich investing in gold. Real estate produces real and growing cash flows that compound over time. Gold produces nada.

The rest of the argument of gold makes little sense to me and suggests we're not on the same page regarding the difference between real value and nominal value. If gold had a real return it would be infinitely valuable. End stop. Whether it's tied to a certain currency for a period, or demand outstrips supply for a period, or it becomes a safe haven in times of hyperinflation, is all neither hear nor there beyond short term gyration. The fact that gold can fluctuate in value relative to a given currency or basket of goods makes it a useful portfolio diversifier (maybe that's a 5% holding, maybe it's 25% holding) but it simply doesn't have a real return over the long term.

I actually agree with this.  Long term one would expect higher returns with an 80/20 portfolio.

But the more, black swans, bear markets and market stressors, the better the PP will do in comparison to a stock heavy portfolio.

In this way, such an aggressively diversified approach is "anti fragile."

I think this is right.

An 80/20 portfolio is probably especially powerful for someone in the accumulation phase, who is effectively buying dips over time. The financial crisis turned out to be a godsend for those adding to their investments over the period, even if they took some short term pain. I'd feel better about the PP if I was a retiree looking to ride things into the sunset.

milesdividendmd

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« Reply #40 on: November 23, 2014, 09:35:03 PM »
Your definition of real estate seems to be conflated with REITS which are real estate investment corporations, with specific rules regarding dividends/incorporation.

By this logic investing in Tiffany is equivalent to investing directly in gold or diamonds or platinum.

Not the same thing.

Real estate and gold are both real assets whose price is determined by simple supply and demand. (This is getting repetitive.)

As demand goes up, so does price, and there is nothing confining demand to the rate of inflation.

The last 40 years tell that story pretty convincingly. (Gold has outpaced inflation by a long shot).

The only counter argument can be that we are on the midst of a 40 year gold bubble.
« Last Edit: November 24, 2014, 12:50:58 AM by milesdividendmd »