Investing Philosophy Nassim Taleb - Balancing Portfolio with Tail Hedge

the Returns versus risk battle is the

front line of investing we all want

higher returns with lower risk but of

course the two are seen as a trade-off

traditional asset allocation deals with

this by striking a balance between risky

and less risky assets typically between

stocks and bonds think of your portfolio

as a pie we can slice it into different

Pieces by these different allocations

the size of each piece representing its

relative size in your portfolio an

allocation of 60% to stocks and 40% to

bonds is a pretty standard Simple Pie in

the investment world the idea behind

this typical waiting as you can see here

is that these two slices stocks and

bonds balance each other in terms of

their risks as they typically go up and

down in opposite directions or at least

don't often collapse together so over

long periods of time and over many

environments this combination should do

pretty well hopefully better than

average some take this Balancing Act

even further adding more slices for

credit spreads real estate emerging

markets and so on and many smart people

with all kinds of complicated formulas

and forecasts and a lot of capital work

to fine-tune this intricate balance but

simple or complex the point here is the

same the problem is all this fine-tuning

doesn't always work out so well all of

these slices at times can get distorted

and manipulated into bubbles as central

banks compress interest rates and lure

investors into ever riskier assets

there's immense pressure to add to the

slices with the highest yield and best

performance and we find ourselves

chasing the most immediately gratifying

as well as the most expensive and

riskiest assets and ultimately

succumbing to these serial bubbles we

even find ourselves here today we're not

owning enough High returning assets like

stocks feels foolish like missing an

opportunity though a very very risky one

so what do you do there must be a better

way than this to allocate capital and

manage this presumed trade-off between

returns and risk well there is what if

you could take a tiny sliver of a slice

of your portfolio pie and invest it in

something that does even better when the

bigger slice stocks goes down notice how

profits in this tiny slice essentially

cancel out the losses in the stock slice

this loss cancellation allows you to

actually take more risk in stocks and of

course being such a tiny slice it

couldn't hurt you much when stocks r

especially compared to what you gain

with your larger stock position no

matter how far that sliver goes down

this sliver thus acts very much like an

insurance hedge hence the name tail

insurance or tail

hedge by allocating say just 1% of your

portfolio to the tail hedge sliver as

universa does by owning put options you

could go from a 60/40 stocks bonds mix

to a much greater stock allocation and

yet your portfolio's total risk would go

down the key here is the tiny of that

sliver relative to how much it can make

when stocks go down or in financial

parlament the asymmetry of that

position this means that when stocks go

up it only costs a very small amount on

its own relative to what it can make

when stocks go down this asymmetry is

challenging to Conventional asset

allocators as it just doesn't fit in

with their conventional models it even

creates what looks like a paradox how

can higher returns possibly come from

lower risk whatever happened to the

tradeoff the real challenge here as well

as the real opportunity lies in a

misperception when looked at an

isolation like this this tiny slice will

look like a disadvantage when stock

markets rally however as we saw when

looked at holistically within the

context of an entire portfolio like this

it becomes clear what a huge advantage

and transformation it can create the

tail hedge allows for a bigger slice of

stocks in the investment pie than the

60/40 portfolio because the stocks are

protected in a steep sell-off the tail

hedged portfolio thus indirectly and

counterintuitively beats the 60/40

portfolio as well as most alternative

Investments and other supposed low-risk

things and as you can see here it beats

them when stock markets

rise and when they fall and importantly

after the fall when everyone else is

selling their stocks notice how the tail

hedge has created all this cash or

liquidity to use to invest in more cheap

in stocks and this is Cash you would

otherwise have only if you had started

with a much smaller stock allocation

so you can see how that tiny sliver of a

hedge in its own indirect roundabout way

in up and down markets can be The Driver

of consistently higher returns for the

entire portfolio investing this way is

what I've been doing my whole career and

it's precisely what universa did for

clients in the 2008 crash and in the

rally that followed moving from a

traditional stock Bond balanced

portfolio to a tail hedge portfolio

requires viewing asset allocation and

risk in a different way holistically

rather than reductively but when looked

at in this way there is no trade-off

there is no Paradox and higher returns

really can come with lower

risk