How to Protect Your Portfolio From Black Swans

Details: Created on Monday, 30 August 2010 16:51; Written by Sara Nunnally, Editor, Smart Investing Daily; Hits: 2666

dividend stocks A Scout's motto is "Be prepared." But how can you be prepared for something completely unexpected? Today's investment markets are riddled with uncertainty, seesawing in poor economic headwinds, and pockmarked with burst bubbles.

We think we've seen the worst, but are we sure about that?

Late last week, the financial market's buzzword was "Black Swan." A black swan is an unforeseen event, random and extremely difficult to predict. Most often, the term refers to something bad.

An article from The Wall Street Journal on Friday was titled, "How to Profit from Black Swans" Here's an excerpt:

A growing number of money managers and financial firms are rolling out investment products designed to exploit big declines known as "black swan" events. Most of the products are geared toward institutional investors such as pension funds, endowments and high-net-worth families – but black-swan strategies are trickling down to Main Street as well.

The point behind this strategy is to take advantage of unexpected stock market moves, but because of the risk and uncertainty of black swans, Nassim Nicholas Taleb – the man who coined the term in his 2007 book The Black Swan: The Impact of the Highly Improbable – says the strategy is designed to be used with only 10% of your financial portfolio, while keeping the other 90% in ultra-safe investments.

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Are Ultra-Safe Investments Really What You Want to Buy?

Today's ultra-safe investments might include T-bonds, which are jumping in price, but dropping in yield... Not the best way to make money.

These new black swan investment products – though timely and with a catchy name – count on being right, and black swans by their very nature are unpredictable. It's a speculator's dream, but the realization of said dream may never come to be.

And with 90% of your money sitting in ultra-safe investments, yielding next to nothing, you might just end up losing money.

Of course, I could be wrong... But in my opinion, you should be making that 90% of your financial portfolio work for you, not sit in some half-baked mattress strategy.

The smart thing to do would be to protect your financial portfolio from these random black swans, rather than try to chase the trend as it screams down the tracks. That does mean putting a chunk of your portfolio in ultra-safe investments, but not the vast majority.

Black Swan-Proof Your Financial Portfolio

Consider the Permanent Portfolio, conceived by Harry Browne in his book Fail-Safe Investing: Lifelong Financial Security in 30 Minutes.

The Permanent Portfolio consisted of four types of investments, each weighted equally: stocks, long-term bonds, cash and gold. The strategy assumes that in prosperous times, stocks would climb. In contracting times, bonds would balance deflation. With rising interest rates, gold hedges against inflation. And cash (or a money market fund) would give you a fair amount of safety.

This gives you a strong base to build a lasting financial portfolio strategy, but it only tells you what types to buy.

You also might want to consider "how" to buy them... And there's one method that can help protect against black swans across these portfolio types.

It's called dollar-cost averaging. Say you wanted to invest in eBay, Inc. (EBAY:NASDAQ) in May when you thought the stock had put in a bottom. You bought $300 worth of eBay at $23.91. As of midday on Friday, eBay traded for $22.66 a share, and you're sitting with a slight loss of 5.2% – if you'd decided to hold on to eBay as it fell through the $20 mark in July.

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Turning Losses Into Gains as Share Prices Fall

Had you put a very conservative 15% stop-loss on this investment, you would've been stopped out in late June.

But using the dollar-cost averaging method, you'd be sitting with a gain of 5.4%!

Here's how it works. Instead of shelling out $300 on May 1 at $23.91 a share, this method suggests spreading that cash out over multiple investments as eBay's price is falling: $100 on May 1 at $23.91; $100 on June 1 at $20.96; and $100 on July 1 at $19.64.

This gives you an average price per share of $21.51. Using Friday's midday price of $22.66 a share, that's a gain of 5.4%.

This strategy can help you mitigate losses, too, thereby protecting you from black swans. With an average cost of $21.51 a share, in early July at eBay's bottom price of $19.06, you'd see a loss of 11.4%, while the lump investment at $23.91 has a loss of 20.3%.

That's a big difference that saves you money – even during black swan events – and can keep you invested in the market and ready for any upswing.

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