Look carefully at the table below; in particular, at the sad little dot alone in the lower left corner, the one that is rung just in case it is not obvious enough, isolated away from the vast majority of the collected dots. This in itself is for a reason. It’s ostracized because it’s dangerous. In its own way, it represents what is most dangerous in investing. Do not consider it as a point, but as a point, perhaps even as the black point of the investment, the equivalent of the eponymous black point which announces the death of Robert Louis Stevenson. Treasure island.

Okay, that’s overkill. Even so, this place is significant. This is a great example of an outlier; an event which can adversely affect the performance of an investment portfolio, just as this particular location attempted to destroy the Bearbull Income Portfolio, the monthly returns of which are shown in the graph.

Almost all long-term equity portfolios will have their own black spot, the short time span which is extremely detrimental to overall performance. The only questions are: are you monitoring your fund enough to know when the damage was done, by how much and why? To this is added the complement: what can be done to limit the virulence of the black point?

Let’s start with the graph. This is a standard regression analysis, from which investors get the ubiquitous “alpha” and “beta” values ​​by which so many fund performance is evaluated. There is nothing smart about it. It begins with a “scattergram” of points. Each of these shows the monthly returns of the Bearbull Portfolio, which aligns with the “ y ” (or vertical) axis, and its benchmark, the FTSE All-Share Index, which ranks by relative to the “ x ” (or horizontal) axis. So, for this lower left outlier, in March 2020, the Bearbull portfolio recorded a monthly loss of 25.2%, by far the worst monthly loss since the fund was launched in 1998, while the All-Share portfolio lost 15.4%. hundred

The scattergram message is made clearer by a trendline, which is essentially the average distance between all points, or all pairs of monthly returns. This determines the point at which the regression line crosses the y axis; this is important, as we will see in a moment. Meanwhile, readers can recall the algebra from their school days and see that the trend line is of the slope-intersection form where the direction and slope of the line is determined by its “ rise on stroke ” – that is, how much the line rises (or falls) for each unit of horizontal displacement.

Intuition can draw a reasonably precise line, but Excel does it instantly and accurately. It even provides the underlying equation that determines the line. This is shown on the graph and tells us that the line intersects the y-axis at near 0.31 (although the dot congregation almost obscures that) and increases at a rate of almost 0.52, which means that for every 1.0 unit of horizontal displacement, the vertical displacement is 0.5 unit upward.

Translating this basic linear equation into the language of investing sheds light on where the Bearbull Portfolio returns come from and, implicitly, provides the best estimate of future returns. Ignoring the very significant effect of dividends accrued and then distributed and focusing only on capital value, the equation tells us that the average monthly fund returns are 0.45%. Of that total, only 0.14 percent comes from the stock market surge, or beta. This figure is derived from 0.52 times “x,” where x is the average monthly return of all stocks, which is approximately 0.27 percent. Meanwhile, 0.31 percent comes from idiosyncratic factors in the fund itself (ie Alpha); or – if I was marketing the fund – it all has to do with stock picking at Bearbull (believe it, if you will).

By the way, one might wonder how representative the trendline is of actual monthly returns? This issue is addressed on the graph by the R-squared value, which measures the degree of fit between market returns and those of the portfolio; the higher the R-squared – up to a maximum of 1.0 – the closer the fit. The R-squared of the Bearbull portfolio of 0.34 indicates that on average the All-Share generates one-third of its returns while other factors determine the remaining two-thirds.

This is another way of saying that UK stocks have only a limited effect on the Bearbull portfolio. Overall, it plows its own furrow and with less volatility than the All-Share Index, making this 25 percent loss month all the more maddening; before that happened, the fund’s worst month on the balance sheet was an 11 percent drop. We could discuss whether this black dot was also one of Nassim Nicholas Taleb’s “ black swan ” moments, but that doesn’t really matter. What’s important is Taleb’s underlying point: that very occasionally, but more often than normal distribution stats tell, doomsday investment riders will strike blows with such ferocity that it is necessary to always protect yourself against them.

It is questionable whether Taleb’s claim is correct. However, assuming this is the case, the question arises: what kind of protection should investors provide? An insurance policy that compensates for losses that exceed a certain maximum is ideal. This is another way of saying “use traded options”. There is no doubt that in theory put options, which give the right to sell at a predetermined price, will do a job.

But two factors militate against their use. The first is the cost. Buying a put option requires a counterparty willing, for a price, to accept the risk that scares the other party. The problem is, the price can be prohibitive, and for put options it’s usually when the markets are tortured by fear. This fear is quantified by market volatility, so high volatility equates to expensive puts. For example, the volatility of the London stock market is typically in the mid-teens, where volatility is measured as the 30-day standard deviation of annualized daily price changes. However, around the peak of Covid-19 fear about a year ago, volatility peaked at 76% and only returned to normal levels this year.

The second factor is the practical difficulties. Finding a broker who will deal with traded options is a tall order. Trading venues and major private client brokers willingly push clients into high-risk hedges – leveraged exchange-traded funds or, worse yet, contracts for difference – but don’t deliver. no ability to trade a sensitive product such as traded options. Of course, there are retail options brokers and a list is provided by ICE, the London Futures and Options Market (www.theice.com/equity-derivatives/retail-brokers). It is also unnecessary that traded options cannot be included in an Individual Savings Account (Isa), although they are suitable for self-invested personal pension plans, and their gains and losses receive the same tax treatment. than those of actions. All of this makes options a messy addition to a conventional Isa-focused portfolio.

Which brings us back to the question, are options the only one-size-fits-all solution to reducing risk? Probably, although proper loading with assets that have a low correlation to stock returns can help. The obvious candidates are gold and government bonds, although they offer no certainty of sufficiently low covariance with equities. Indeed, the tendency is for bond prices to move at the same rate as stocks, even if rising inflation could put an end to it.

Also, the options may not be really worth the effort. Much depends on the attitude of each investor towards losses, although those in the equities game should have courage for the dips. After all, a 10-15% drop over the year isn’t a problem, and Taleb’s underlying point is that only really big drops warrant insurance coverage.

Yet it’s not just the severity of the drop that matters, its longevity is also important. Consider the effect of a 25% drop, is it better to happen over a month or over a year? The loss will be the same. The difference is that with the 12 month loss in value, the recovery begins 11 months later. Assuming the same pace of recovery in both scenarios and then two or three years into the future, an investor will be better off to have suffered the heartbreaking one-month drop than the barely noticeable 12-month erosion.

Fortunately, the markets tend to move fast and furiously when they fall and, even for the Bearbull portfolio, that 25% drop 14 months ago, which took £ 65,000 from a £ 258,000 portfolio, has now been corrected. That said, the All-Share, which only fell 15% that month, caught up – just – at the end of 2020. This explains why the All-Share is now 8.4% higher. high than at the end of February. 2020 while the Bearbull portfolio, despite rising 13% in the first four months of 2021, is still only growing by 5.7%.

Investors can also take comfort in thinking that they are generally more diverse than they realize. It’s not just an investment portfolio that their wealth is poured into; most likely there will be property, savings policies and working income too. So a Black Spot investment becomes just another one of those bugbears to be tolerated but never eradicated. Even so, it is useful to compile data indicating the worst that a black spot could bring.

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