Black swan events are the new normal if you listen to the news, especially the financial press. There is always something out there that is going to take down the financial markets and the rest of the world, and sometimes bad things actually happen. Then Financial Crisis absolutely crushed the markets. So did the Great Depression and 9/11. And yes, some people predict downturns. But even a broken clock is right twice a day.
But by definition black swan’s are rare and unpredictable. The only way to protect yourself from the truly unpredictable is to set up shop in your own off the grid fallout shelter and never come out, but that is just no way to live. Similarly, always expecting the imminent collapse of the financial markets is no way to invest. The real return on cash in the mattress is the inflation rate, in reverse.
Black swan event and markets
So how do you invest knowing we have these black swan's lurking about ready to spring on us as soon as a virus in China spreads, or dictator in North Korea or Iran pops off a missile, or the latest worry, an elected leader tweets?
One old school answer is you patiently wait through it, allowing time for the market to recover. There is absolutely a lot of validity in that approach. Markets have always recovered, eventually. However, it is tough to wait it out if you have expenses to pay now, and Murphy’s Law, and economics, dictates that you will likely need money when the market is down.
There is also another old school answer, the Benjamin Graham / Sir John Marks Templeton approach. You wait and invest at the point of maximum pessimism. The market is after all, very efficient at taking money from inpatient investors and giving it to patient ones. Value investing still makes sense, even in the era of the market bull being dominated by a small number of tech stocks, aka FAANG. However, if you missed investing in the last market bottom back in 2009 and have been waiting ever since for the next big correction, when exactly are you going to be able to get back in at a bargain?
However, is there possibly another answer, a more contemporary strategy to dealing with black swans?
One is from the institutional world made famous by David Swensen, guru chief investment officer of the Yale Endowment. It argues that investors should include more real estate, private equity, and venture capital in their portfolios.
Black swan events and portfolio management
But what percentage of a portfolio should be made up of these alternative investments?
The most recent information released by Yale on their endowment shows just 16.5% of their portfolio is allocated to equities, and 84% of that was to foreign equities.
However, if you look at the most recent numbers, Yale’s Endowment only returned 5.7% net from July 1, 2018, to July 1, 2019. The ten-year return of 11.1% trailed the return of the US stock market by a whopping 3.6% annually. To be fair, the Yale Endowment is an income portfolio, paying more than a third of all of the university’s expenses; and the drag from 30% of the portfolio being in cash, bonds, and absolute return investments is substantial, but maybe the Endowment Model has drawbacks as well.
So what should you do now? How do you invest prudently with a black swan event out there ready to spring out of the blue, the stock market at highs, bond yields low, a flat yield curve, etc., etc.? How do I allocate today?
I do all three.
The Endowment model offers good returns, stability and income. I allocate there, with the income constantly providing more cash, initially to reinvest and eventually to live off of. Then I invest in the stock market, diversified and globally, adding when the total market or a sector I believe in corrects and hold through any subsequent corrections where I likely will be buying again.
There are times to sell off equities, but that will be based on someone’s specific situation, and best to be done when the market is high, like now. And don’t forget taxes. Never forget taxes. The best way to increase returns is still to avoid taxes so you keep more of your own money, but that is a discussion for another day. For more on how to defer capital gains taxes, please see my earlier post on ValueWalk.