Friday, March 4, 2011

Managing extreme tail-risk market events

Are you worried about losing money in the market but don't want to miss the rally? That's the conundrum posed by my post Thinking bearishly, trading bullishly. In that post, I outlined my concerns about the market, namely:
  • Chinese slowdown
  • European sovereign risk
  • US municipal bond implosion
  • Further weakness from US real estate
On the other hand, my inner trader was staying bullish in the face of these risks because of bullish technical and sentiment readings. However, I remained highly aware of these extreme tail-risk events which could derail the markets.

CXO Advisory wrote a timely piece entitled Overview of Research on Asset Allocation in the Face of Disaster and they concluded that current asset allocation practices didn't have a clue of what to do in the face of these extreme events:
[E]vidence from surveys of relevant research indicates that academia has made little progress in finding practical ways for investors to protect even diversified portfolios from extreme events (crashes).

Market timing: Avoid extreme risk, but allowing winners to run
Under these kinds of volatile market conditions, allocating some funds into market timing strategies makes sense. Abnormal Returns also discussed different approaches to market timing, of which the Inflation Deflation Timer Model is one of the variants.

I know that the term "market timing" is a four-lettered word in some quarters, but given the current environment where extreme tail-events are more likely, buy-and-hold strategies are likely to lead to sub-optimal results.

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