james montier headshotThis is the latest from James Montier. Montier discusses the increasing popularity of tail risk protection strategies. M0ntier notes the flaw in using various “tail risk” investment strategies. One flaw Montier notes, is that since so many investors are trying to use these “tail risk” protection tools, the price of for example put options will be driven up, hence paying a very hefty price for this protection.

Towards the end, Montier quotes my favorite philospher/thinker, Nassim Taleb.

Nassim Taleb in one of my favorite books The Black Swan,  defines a black swan as a highly improbable event with three principle characteristics: 1) it is unpredictable; 2) it has a massive impact; and 3) ex post explanations are concocted that make the event appear less random and more predictable than it was.

Montied quotes further from Taleb: It should be noted that some black swans are a matter of perspective. Taleb asks us to think of turkeys in the run-up to Thanksgiving. From the turkeys’ perspective, each day a kindly human arrives and treats them to fresh water and feed. Then, suddenly, a few days before Thanksgiving, the very same human massacres all of the turkeys. Clearly, from the turkeys’ point of view, this was a complete black swan event. But from the farmer’s perspective, this was anything but a black swan.

Below is an excerpt, followed by the full document in scribd.

Long ago, Keynes argued that the “central principle of investment is to go contrary to general opinion, on the grounds that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.”

This powerful statement of the need for contrarianism is frequently ignored, with disturbing alacrity, by many investors. The latest example in the long line of such behavior may well be the general enthusiasm for so-called tail risk protection.  The range of tail risk protection products seems to be exploding.  Investment banks are offering “solutions” (investment bank speak for high-fee products) to investors and fund management companies are launching “black swan” funds.  There can be little doubt that tail risk protection is certainly an investment topic du jour.

I can’t help but wonder if much of the desire for tail risk protection stems from greed rather than fear.  By which I mean that it seems one of the common reasons for wanting tail risk protection is to allow investors to continue to “harvest risk premium” even when those risk premiums are too narrow.  This flies in the face of sensible investing.  A safer and less costly (in terms of price, although perhaps not in terms of career risk) approach is simply to step away from markets when risk premiums become narrow, and wait until they widen before returning.

The very popularity of the tail risk protection alone should spell caution to investors.  Keynes’s edict with which we opened would suggest that the degree of popularity of tail risk protection helps to undermine its benefits. Effectively, you should seek to buy insurance when nobody wants it, rather than when everyone is excited about the idea.  An alternative way of phrasing this is to say that insurance (and that is exactly what tail risk protection is) is as much of a value proposition as any other element of investing.

As always, a comparison between price and value is required.  One of the nice aspects of insurance in an investment sense is that it is generally cheap when its value is highest (although this may no longer be the case given the rise of so many tail risk products).  That is to say, because most market participants appear to price everything based on extrapolation, they ignore the influence of the cycle.  Thus they demand little payment for insurance during the good times because they never see those times ending.  Conversely, during the bad times, the average participants seem willing to overpay for insurance as they think the bad times will never cease.

The “What” of Tail Risk

It should be noted that tail risk protection is a very vague, if not actually a poorly defined, term.  In order for tail risk protection to make any sense at all, it is vital to define the tail you are seeking to protect against.  There is a plethora of potential tail risks one might seek insurance against, but which one (or ones) do you have in mind?  As one of my logic teachers reminded us almost weekly and Voltaire advised, “Define your terms.” We suspect that at the most general level, the tail risk the majority of investors are concerned about is a systemic illiquidity risk/drawdown risk (as was experienced during the 2008 crisis).  Of course, this ignores another of Keynes’s insights.  “Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities.  It forgets that there is no such thing as liquidity of investment for the community as a whole.”  But, for the time being, let us assume that systemic illiquidity problems are the tail risk that most investors are seeking to offset.

James Montier on Tail Risk