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On Dec. 17, just as pundits were carefully putting together their predictions for the world in 2011, a 26-year old Tunisian street vendor set himself ablaze in protest against arbitrary police authority. Who could have imagined that this would be the tinder for a series of uprisings that has gripped North Africa and is now the focus of global financial markets? That's the nature of the Black Swan, an unpredictable event with dramatic consequences. Is it desirable to hedge your portfolio against this type of risk? And if so, how does one go about it?
Pick your Black Swan
It's easy to dismiss the impact of the events unfolding in North Africa, but even if it's ultimately limited with regard to your portfolio, it's easy to imagine numerous other unsettling scenarios:
- What if the riots that occur periodically in rural China become more frequent and more difficult to suppress, threatening the ability of the Chinese Communist party to maintain the nation's cohesion?
- Ireland is holding a general election this week. What if the new Irish government forces banks' senior creditors to take losses, producing a ripple effect through the European banking system?
- On the same topic, what if Greece imposes a haircut on holders of its government debt? (I'm joking here; this is anything but a Black Swan, more like a foregone conclusion.)
Black Swans are out there. Here are four ideas for possible hedges against them.
S&P 500 options
It took civil unrest in Libya to finally affect sentiment in U.S. markets. Libya is a member of OPEC, and the serial uprisings we have witnessed highlight the tension simmering in populations across North Africa and the Gulf states, including Saudi Arabia. Any significant disruption in the oil supply would have momentous implications for the global economy.
In that context, U.S. stocks are certainly vulnerable to a correction, after staging an extraordinary two-year rally off the March 2009 low. A straightforward way to hedge a U.S. stock portfolio is to purchase puts on the SPDR S&P 500 ETF (NYSE: SPY ) -- or the Russell 2000 Index ETF (NYSE: IWM ) if your portfolio is tilted toward small-cap stocks. Put options increase in value as the price of the underlying asset falls and as volatility increases.
An imperishable commodity and a supra-national currency that is no government's liability, gold is the original Black Swan hedge. I've argued that gold is overpriced at these levels, so I'm not a proponent of owning the metal outright. Nonetheless, there is little question that further geopolitical turmoil could send prices of the yellow metal spiraling higher. Recall that gold achieved its all-time high in January 1980, the month that followed the Soviet invasion of Afghanistan.
If I were to use gold as a hedge, I'd buy call options on the SPDR Gold Shares ETF (NYSE: GLD ) or the iShares Gold Trust (NYSE: IAU ) with a strike price well above the current price of the ETFs. Call options increase as the price of the ETF increases and as volatility increases. Note that these options aren't cheap, as gold is a volatile asset.
U.S. Treasury bonds
Despite mounting concern about the United States' fiscal position, U.S. Treasury bonds remain the financial asset of choice in a flight to safety. For example, in the fourth quarter of 2008 -- the height of the financial crisis -- the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT ) rose from $94.88 to an intraday high of $123.15. Fair warning: Treasury bonds don't look like a tremendous value right now; instead of increasing one's allocation to bonds, investors could consider buying out-of-the-money call options on this ETF.
The VIX Index
The VIX index is nicknamed Wall Street's "fear gauge." It measures the volatility of options on the S&P 500 index. During periods of turmoil, investors will pay up for downside protection, bidding up S&P 500 put options, which translates into higher values for the VIX index. This index can be very volatile, as my colleague Morgan Housel highlights here. Call options on the iPath S&P 500 Short-Term Futures ETN (NYSE: VXX ) are a possibility, but I'm not convinced this is a good choice because of the discrepancies between the VIX index and the ETN, which owns VIX futures.
Discipline and liquidity
Options are sophisticated products; investors should have a firm understanding of their mechanics before even considering any of the hedges described above. Furthermore, we are discussing a form of insurance, so it should be understood that making money isn't the goal here. Finally, this type of protection can be expensive. Ultimately, the individual investor's best insurance may come down to discipline and liquidity: Leave yourself a margin of safety by never overpaying for any asset, and increase your cash position when general exuberance causes asset prices to outstrip intrinsic values.
Gold may be a hedge, but This Tiny Gold Stock Is Digging Up Massive Profits.