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Makin' Money

Cash is king

Chris Farrell Jun 29, 2011

You’ve probably heard of a “black swan.”

The provocative catchphrase comes from a best-selling book by author and investor Nassim Nicholas Taleb. A black swan is essentially an unpredictable outlier event that has a dramatic impact on the economy and society. It gives lie to the elegant quantitative and mathematical models most experts use to predict the future course of the financial markets and economy. It’s almost comforting to know that the surprising twists of history can fool even the most highly regarded financial and academic eminences. Black swans are popularly considered negative events, largely because the fearsome global credit crunch–missed by most mainstream forecasters–made many people appreciate the phenomenon. (Yet there’s nothing intrinsically bad about black swans.)

Wall Street rocket scientists have been busy coming up with all kinds of financial products to “protect” investors from bad black swans. Many of the more popular products involve exchange traded funds. The idea is to allow you to maintain your riskier investment portfolio–like stocks–while taking out insurance against an improbable but ominous event. The jargon term is tail risk protection.

James Montier hangs his hat at the European branch of GMG, the Boston-based money management firm with a sterling reputation for long-term long-term investing.

Montier is an expert in behavioral finance and investing. His pieces are always worth reading. He takes a jaundiced look at tail risk protection in an article for GMO.

It’s buyer beware–Caeat Emptor.

Tail risk protection appears to be one of many investment fads du jour. All too often those seeking tail risk protection appear to be motivated by the fear of missing out (not fear at all, but greed). However, the surge of tail risk products may well not be the hoped-for panacea. Indeed, they may even contain the seeds of their own destruction (something we often encounter in finance – witness portfolio insurance, etc).

He goes into the topic in depth. It’s a fairly technical discussion, but the simple takeaway for most of us who invest for our retirement in a 401(k) or the like is steer clear of tail risk protection. Don’t waste your money. Don’t waste you time. Forget the fancy stuff. There is a very simple alternative available to us. It’s called cash–T-bills, checking accounts, savings accounts, certificates of deposit, and the like. (I missed this story in today’s New York Times on these tail risk products. I’m adding it now. It goes into detail about the pitch and the workings of buying insurance against financial catastrophe. It makes the Montier skepticism even more important.)

When considering tail risk protection, investors must start by defining the tail risk they are seeking to protect themselves against. This sounds obvious, but often seems to get scant attention in the tail risk discussion. Once you have identified the risk, you can start to think about how you would like to protect yourself against that risk. In many situations, cash is a severely underappreciated tail risk hedge.

Little wonder Montier’s article is an “Ode to the Joy of Cash

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