Planning for the Black Swan Part II

Risk Assessment
July 16, 2023

In another article we discussed how we were caught off guard from a major hurricane that was predicted to sweep across Florida in an atypical direction. Normally, hurricanes in Florida move across the state from east to west and only affect a portion of the population. In 2017, Irma was predicted to move from the south to north potentially affecting almost everyone in the state. We discussed how we learned from that experience to move early on potential disasters and risk being wrong.

Here's a case where the lesson I learned from Hurricane Irma was only partially implemented. The part that wasn’t implemented, namely portfolio insurance or hedging strategy, was my most expensive mistake to date.

In 2020, my daughter was attending school in CA and I was there with her. We were aware of the COVID-19virus and had worn masks when we flew to San Francisco at the end of January. We were closely following the news about the virus. Towards the middle of February, we saw the news was getting worse. The end of the school semester was the middle of March and my daughter wanted to finish on campus.

During the last week of February, there was more information about the exponential spread of COVID-19, and I was having trouble sleeping. I didn’t want to get locked down in our apartment in CA. On Friday, February 28, I booked a flight home to Florida the next day. I asked my daughter to pack what she needed as we were leaving the next morning. She wasn’t thrilled about missing the last 2 weeks of the quarter but understood my distress.

When we got home, the first thing we did was go to Costco to stock up on essentials. The last package of toilet paper had just been sold. We spent the next couple weeks working on the logistics of getting adequate food, additional refrigeration, arranging transportation to get my son to our house in Florida and other disaster preparations. These preparations were much different than hurricane planning. With a hurricane, you either go somewhere else where there isn’t a hurricane, or you insure you have a 5 to 7 day food supply and stick it out. Not a viable option when the virus could be everywhere.

While we were busy preparing for a potential armageddon, the S&P 500 was down 12% from March 4 to March 9. By March 16th, it was down almost 25%. As we were flying home, we discussed options to protect our equity assets. We had large gains in the portfolio, so selling everything and paying a 24% capital gains tax that would have been substantial, wasn’t an attractive option. We’re very long-term investors and liked what we owned. We considered put options on the S&P but the premiums were very high. We didn’t have a financial plan for this type of black swan event.  Starting to research low-cost hedging options while you’re concerned about having an adequate food supply is suboptimal. You need a plan in place that you can implement in a day or two. That might be all the lead time you have before everyone else is trying to get out through the same door.

There are funds, like Universa, that provide black swan (tail risk) strategies. From what I’ve read, Universa can protect your portfolio against large losses at a cost of about 3%/annually. This takes a large bite out of the average 8%, long term, annual return of the US Equity market. The goal would be to buy this type of hedge at the first sign of a potential catastrophic event and then exit if the event doesn’t occur. If you can protect your portfolio for a cost of 1% for a few months, that would be useful for us.

As very long term investors, the hedging strategy is more to create an opportunity to buy assets at fire sale prices than to insure against permanent losses. If you’re fully invested in an index fund, and the market drops 50%, there’s not much you can do to take advantage of that type of opportunity unless you’re willing to buy on margin. A well-constructed hedge should generate capital you can deploy to buy assets at temporarily depressed prices.

We try to accomplish some of this with a diversified portfolio. When the market crashed, not all stocks dropped equally. We sold some of our defensive positions that held up well and used those funds to add to our positions that dropped the most. We should have been prepared with a low-cost hedge strategy. If we had, we could have deployed it on 2/28 before we hopped on a plane. That would have generated a lot of capital to scoop up all the bargains created by the panic. We’ll make new mistakes, but I don’t expect to repeat the old ones.