What Is a Tail Hedge Strategy?

By definition, a tail hedge strategy is designed to protect investors and their portfolio from the risk of a significant stock market crash.

What is a “tail” event?

A “tail” event is often described as a large unexpected decline in the stock market. Some memorable examples include the start of the COVID-19 pandemic in March 2020 when the market fell ~40%, or in 2008 when the market plummeted during the financial crisis. Other crises like October 1987 or the Great Depression in 1929 also highlight this phenomenon as a recurring feature of markets.

The wealth management industry likes to believe they can predict when these downturns and events will occur – but the reality is, these tail events are random, unpredictable and can happen at any time. They usually come out of nowhere and are often unforeseen to the market. It’s usually these large drawdowns that can throw off an investor’s ability to compound wealth over the long term. The loss of wealth that occurs in a market crash can derail an investor’s retirement plans. If investors can avoid and minimize the impact of these wipe-out events — which seem to be happening a lot more frequently — this can play an instrumental role in their ability to accumulate and protect wealth over time.

Why traditional diversifiers aren’t working

Traditional portfolio diversifiers like bonds and gold are usually the “go to” during market downturns to minimize the impact; however, they have not been as effective as they have been historically. For example, in March 2020, your portfolio would have needed to be in 50% long-dated government bonds to have a flat portfolio, or 75% in gold. At the same time, you would have had to get the timing right and then suffer the underperformance of being overweight those asset classes, which means you wouldn’t have been able to participate in any large broad market rallies. In this scenario, you’re giving up too much of the upside and the cost of protecting your portfolio is too high.

Bonds have been less effective than in previous market cycles because interest rates are so low and it’s been hard to generate a return that’s even equal to inflation. Additionally, owning different sectors of the stock market doesn’t matter as much during a wipeout market event because of how correlated and highly levered markets are – everything goes down during these types of downturns.

Why a tail hedge strategy a good idea

Put simply, a tail hedge strategy can help investors achieve the same level of protection without capping your upside like it did in the previous scenario mentioned. A tail hedge strategy is structured so that you own something that will go up when the market goes down. And if the stock market has a strong year then the rest of your portfolio benefits, and the cost of the tail hedge remains very small relative to your portfolio size. It’s a way to protect the portfolio so you are able to compound your wealth over the long term without any substantial roadblocks.

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