CAPITAL PRESERVATION IS A TRICKY BUSINESS

Capital preservation is a tricky business. Its importance to investors - particularly the affluent - is unquestioned, but balancing satisfactory portfolio returns and minimizing downside risk (such as risk of large losses) requires attention and sophistication.

Fortunately, minimizing 'normal course' volatility (say, market returns within one standard deviation of the mean return of the portfolio) can be achieved through proven techniques in normal market conditions - like keeping investments' correlations low by diversifying by currency, asset class, market capitalization, geography, etc. While a long term horizon and a diversified portfolio do not eliminate downside volatility, the combination can smooth much of the market 'bumpiness' that can interfere with a good night's sleep.

This would all be fine if the market's returns were normally distributed, like they would be on the smooth Gaussian bell curve the world of finance is so familiar with. If returns really looked like that, the vast majority of market returns would fall within those two standard deviations and the 'tails' would be whisper thin and hardly worth fretting about at all.

The problem is that the left tails - the damaging ones - are fatter than the famous bell curve would suggest. A lot fatter.

In the past 50 years, losses on 20% or more in the S&P 500 in a single (rolling) quarter occurred 169 times, and losses of a magnitude of 30% or more occurred 23 times. The future portfolio returns and the length of time required to regain losses suffered during those times makes it tempting to simply pretend that they won't show up at all.

These 'tail-events' are often referred to as 'Black Swans', a phrase coined by Nassim Taleb: (New York Times, April 2007): “What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.  I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability.”

Financial history is littered with examples of Black Swans: the 1987 stock market crash, the 1990 Japanese real estate collapse, the 1998 Russian default and LTCM collapse, the collapse of the 2000 tech market bubble, the collapse of the 2007 global real estate bubble, and the 2008 financial meltdown, to name a few.

In many ways, these 'Black Swans' are the financial equivalents of earthquakes...the damage they wreak can be catastrophic and seem rather easily explained in hindsight - after all, could we not tell that tectonic pressures were building and that early tremors were the signal of worse to come?

If we choose to live near fault lines, it is important to take steps necessary to make portfolios robust to tremors instead of trying to predict when they will occur. The unpredictable nature of Black Swans makes defending against them using standard portfolio techniques virtually useless (much like the films in the 1950’s that implored children to hide beneath their desks in the event of nuclear Armageddon) - but there are ways in which portfolios can be immunized against such events through tail protection strategies. It is a small wonder that investment allocations to those strategies have mushroomed from $500 million in September 2008 to about $40 billion by the summer of 2011 (Reuters, January 2012). Investors seeking a measure of portfolio protection against Black Swans would be well served by learning more about them.