Managing Risk Through Unforeseen Events

The theory of “black swan events” was originally developed by Nassim Taleb to profile unexpected occurrences or rare events that few were able to predict or prepare for.  The recent tragedy of the plane crash along the Ukraine-Russian border that led to a swift global sell off is one such occurrence that caught nearly everyone off guard. And events like these add another element to managing risk.

From a regional perspective, many stocks in Russia and other Eastern European nations fell more than 7% in a single day on this news.  Despite the quick rebound in equities on the subsequent day of trading, there were still many areas that experienced a significant jolt and will feel the effects for some time.

wall street managing risksThe speed of information in this day and age helps propel markets very quickly in both directions.  Black swan events can materialize through natural disasters, geopolitical wrangling, terrorist activity, and a host of other causes.  As a result, it bears repeating that managing risk through unanticipated news events is essential to capital preservation.

Your first step in managing this risk is understanding the layout of your equity exposure.  Frontier markets are considered more uncertain than emerging markets, which are in turn riskier than developed markets.  The farther out on the risk spectrum that you sit should translate into a much higher level of awareness for these types of assets.  Of course, risk is a two way street, as heightened levels of uncertainty can also produce the most fortuitous results when the chips fall your way.

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One method of reducing this risk is through diversification.  You can reduce your risk of single-country or regional exposure by choosing a broader international index to spread your asset allocation among varying countries or sectors.  In this most recent example, swapping the MarketVectors Russia ETF (RSX) for the Vanguard Emerging Market ETF (VWO) would allow you the ability to still participate in the growth of Russian equities along with several other developing nations.  VWO has 6% of its portfolio dedicated to Russia and only fell 2% on the same day that RSX fell 7%.

Another way to potentially insulate your portfolio from geopolitical risk is through alternative asset classes such as gold or oil which typically rise during times of global uncertainty.  The SPDR Gold Shares ETF (GLD) and iPath S&P GSCI Crude Oil Total Return ETN (OIL) both jumped 1.7% on the same day of the plane crash.  Long duration treasuries such as the iShares 20+ Year Treasury Bond ETF (TLT) is another safe haven alternative that can be considered as well.  Small allocations to these areas can be an effective way of managing risk by insulating your portfolio from specific threats. It can also act as another method of diversification.

Finally, the use of trailing stop losses is a fail-safe to define the amount you are willing to give back before you exit an investment and stand aside.  Despite the best intentions, bad timing or unpredictable events can lead to significant losses without a sell discipline in place.  I believe this is the single most underutilized tactic for undisciplined investors that often allows a bad trade to turn into a bad investment for an extended period of time.

When utilizing a stop loss, there is always the potential that your exit point will be hit and the investment will immediately turn around and head higher.  However, I would rather be caught in a whipsaw like this for a small loss than see a significant portion of my capital wiped out by falling prices.

Remember that each investor will have a unique approach to constructing their portfolio to weather the storm of unforeseen events.  Recent history has rewarded the “do nothing” approach because every sell off has been shallow and short-lived.  However, there will come a time once again when risk management will play a key role in your psychological and capital survival.

The author has a position in VWO at the time of publication.  Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.