If you are depressed by all the money you have lost in the stock market, learn to take advantage of the chaos

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As you’ve probably noticed, stocks are a little more volatile these days. We have reached levels of volatility similar to those we experienced during the 2008 financial crisis and, before that, the Great Depression. It’s quite intense.
I can tell you one thing: if you can manage this, you can manage everything. I would characterize any movement of more than 2% on the stock market
SPX,
+ 0.86%

also big. Ten percent is, well, the largest since the 1987 crash.

In a purely vanilla sense, you’re probably wondering how to mitigate the volatility of your freaking portfolio. You can enter your time machine, go back a few months and buy bonds. Except, even the bonds
TMUBMUSD10Y,
0.797%

don’t help now.

Nothing works

All kinds of wacky things happen in the bond market, and bonds don’t really offer any diversification benefits as risk parity strategies unfold.

Gold
GC00,
-1.34%

is expected to provide some diversification benefits, but it doesn’t, due to liquidation. Commodities, no help. Real estate, no help.
The harsh reality: in a crisis, the correlation goes to one, and everything happens at the same rate. And that’s the problem with 95% of the portfolios.
Correlation is the risk that no one sees. The correlation is the risk that no one saw in 2008, which was precisely the cause of secured debt securities (CDOs) and such explosions. The correlation is still hidden. It’s the relationship between currencies and bonds and stocks and banks and people you don’t see until it’s too late.
The correlation makes strange things happen. I’ve heard of a high yield bond fund that fell 16% in one day. It shouldn’t happen in a million universes. Correlation. Someone is losing money there, so they have to sell a winner here. This is happening thousands of times in the markets right now.
Stocks, bonds, currencies, gold, everything moves like a fanfare – but unexpectedly. You don’t know where the weaknesses are until it’s too late.

Fragility

I’m going to borrow a little Nassim Taleb for a paragraph – this is the difference between building wallets that are fragile and those that are anti-fragile. As most people have discovered in the past few weeks, their wallets are fragile. Most people have.
You want to build a portfolio that gain disorder. Few people have done it, other than some flight funds and guys at risk of queuing, who do this kind of thing for a living.
You can’t be a tail risk fund, so don’t even think about it.
The reality is that we are all more or less long term investors, and once every 12 years we will be clubbed with a club. You can take steps to mitigate this (like the 35/65 portfolio), but the trade-off is lower returns. So, is there no hope?
Let me talk briefly about the exchange of feelings and asymmetry. One of the cool things about being a sentiment trader is that you always bet against the crowd. If people are excessively bearish, you are optimistic, and vice versa.
The good thing about this is that it frequently places you in low risk trades where there is asymmetry – you can win more than you can lose.
Of course, none of us know what the true probability distribution is, but if you have experience and a nose for crowd psychology, you are a little bit likely to gain a lot, rather than a lot to risk to make a little.

The source of value investment

Whenever I negotiate, I think of this asymmetry (which some might call option). This is one of the reasons why I have run out of Canadian banks for all these years – even at the best of times for Canadian banks, I have never seen many benefits. And it was the right call.
Value investors do it too – they invest in safety margin. Sentiment trading is a distant cousin of value investing.
When you invest this way, you tend to be less exposed to large shocks. You will often have built a portfolio that takes advantage of the mess. And it’s always useful to have a hedge – buying a few deep puts out of the money is never a bad idea, as long as you remember selling them.
If you didn’t do it right this time, for the killer virus, make sure you do it the next time, when the asteroid hits.
Jared Dillian is an investment strategist at Mauldin Economics and a former ETF trading manager at Lehman Brothers. Subscribe to his weekly investment newsletter, The 10th Man, and listen to his daily radio show, The Jared Dillian Show. And follow Jared on Twitter @dailydirtnap.

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