Everyone seems to be looking for a big score from the markets. Yet time and time again, what's proven to be the best strategy is to take a more conservative, long-term approach with your investments. Too often, if you try to put all your money in one basket, you'll end up with nothing.
An article in the Wall Street Journal over the weekend observed how an increasing number of investors are looking for ways to profit from an unexpected event, such as a market crash. Known as black swan events, these surprises cause huge amounts of turbulence in the markets, and for most investors who own stocks, they can bring big losses in a short period of time.
Some of the strategies people use to cash in on black swan events, however, are exceptionally risky. Sophisticated hedge funds use securities like index-based derivatives and privately placed investments to try to take advantage of underestimates of "tail risk" in certain markets. Even average investors are getting in on the action, using mutual funds like Pimco's Global Multi-Asset Fund as well as protective put options to try to protect themselves from a potential downturn.
The article suggests, though, that such strategies are necessary because old-style diversification hasn't worked well recently. Proponents of black swan strategies argue that during the financial crisis, most markets moved downward at the same time, and therefore those who counted on diversification to save them were sorely disappointed.
Missing the forest for the trees
It's entirely possible that black swan-based strategies may be smart long-term plays. If the markets are indeed underestimating the chance of a catastrophic downturn, then investing a portion of your portfolio could indeed be the right thing to do. Investors like hedge-fund manager John Paulson, for instance, made a killing taking the unpopular position that a housing bubble would burst.
But focusing entirely on black swan events means taking your eye off the real goal of your investing: to maximize your wealth over the long haul. It's true that protecting your wealth during bad times is just as important as, if not more important than, maximizing your gains during a bull market. It's true that it can be almost impossible to recover from a big loss. If you're not careful, though, the protect you try to buy can be so costly that it takes away any chance you have of reaching your goals if the worst-case scenario never happens.
Protection that'll bankrupt you
Take a closer look at protective puts. By buying put options, you can completely eliminate the chance of a huge loss while retaining any upside if the stock rises. But you have to pay the option price to get that protection, and that price can be higher than you think.
For instance, consider two low-risk stocks, Exelon (NYSE: EXC ) and Altria Group (NYSE: MO ) . Both pay healthy dividends and have a strong position in relatively recession-proof industries. But for just five months of protection, you'll have to pay more than 6% of their current stock price.
If you own companies with greater upside potential, you'll pay even more for protection. For instance, emerging-market stocks Baidu (Nasdaq: BIDU ) and Vale (NYSE: VALE ) are seen as having higher potential growth than even their counterparts elsewhere in the world, and investors are paying up for those prospects. To protect yourself from a bad bet, however, you'll pay more than 10% of the current share price to buy put options that will expire in mid-January 2011.
Diversification still works
Moreover, those who say diversified portfolios failed during 2008 and 2009 simply didn't own the right investments. Corporate bonds did suffer along with stocks, especially those issued by companies like Sirius XM (Nasdaq: SIRI ) and Ford Motor (NYSE: F ) that were on the endangered list for a while. But if you stuck with Treasury bonds, either directly or through the Treasury-specific ETF iShares Barclays 20+ Year Treasury (NYSE: TLT ) , then you saw a 34% gain in 2008 to offset that 43% drop in the S&P 500.
The prospect of a black swan event is interesting and worth thinking about. But if you let it dominate your attention, you'll miss out on smart investing opportunities throughout the market. In contrast, if you can stay focused on the big picture, you'll be more likely to reach all of your long-term investing goals.
The best bet you'll ever make is to go against a pessimistic crowd. Jordan DiPietro explains why you shouldn't fall for the worst stock myth of the decade.