How will you protect your portfolio against systemic shocks such as market panics?

The Master Investor has structured his portfolio and investment strategy so that he will survive even the most extreme market conditions.

If the market collapses overnight, will you live to invest another day?  You have to structure your system so that the answer to this question is "Yes!"

The first thing to do is to acknowledge that anything can and will happen in the markets.  Generate several worst-case scenarios in your mind.  Then ask yourself:  if any of these things happened, how would you be affected - and what would you do?

The Master Investor's primary protection is their judicious use of leverage.  Every time the market crashes we hear stories of people who lose their shirt because they were over-leveraged.  The Master Investor simply doesn't get himself into this position.  

Black Swan events

These aren't predictions — any fool can make a prediction.

A Black Swan event is, by definition, unpredictable.

In the last few years, we've been hit on a number of these events that came out of the blue and destroyed with a vengeance; the biggest of these was the credit crisis in fall 2007.

Failure of a 'foolproof' gambling system

Calculating the true odds is quite complicated, but once every 28 or so times you begin the betting sequence on a 37-number wheel, you should expect to lose your entire capital base. I've dubbed this ''the Fairstar principle'':


Risk & reward

Consistent small wins can disguise the true relationship between risk and reward. 

A lack of appreciation of this principle has cost investors billions over the past three years. Funds run by the likes of Basis Capital, as well as the implosion of RAMS Home Loans can be linked back to the Fairstar principle.

Why? Because the business models were based on strategies that involved regular small wins (and, in the case of the funds, accompanying performance fees) until, one day, the unlikely event (or ''black swan'') turns up and calls ''time'' on the party.


http://www.smh.com.au/business/failure-of-a-foolproof-gambling-system-20100428-trch.html



Here is a good comment:

Any roulette system which starts with observing the behaviour of the wheel and when some particular pattern is observed, such as the "three consecutive same colours" commences operation, supposes that the wheel (or the ball) has a memory, which it does not.

Each spin is an event in itself, and what happened before is of no matter.

There could have been 100 consecutive reds and on the next spin red and black still have an exactly equal chance of occurring, assuming that the wheel is not rigged in some way.

"Common sense" might suggest otherwise, and that after 100 reds black MUST be overdue but common sense isn't common at all!

Doubling up to chase losses is a very risky business, if Bill Gates and Warren Buffett tossed a coin for a dollar a time and went "double or quits" after each loss one would eventually bankrupt the other.

And it would only take something in the order of 36 consecutive "double ups" for it to happen.

In fact, this is why casinos have table limits. Many people think they exist to protect the punter, but in fact they are to protect the casino from a punter with sufficient resources and nerves from continually doubling up until he wins.

If more punters studied elementary probability they would lose a lot less.

Reformed Gambler | Canberra - April 28, 2010, 2:01PM

To quote Albert Einstein, who knew a thing or two about maths: "The only way to win in Roulette is to steal from the croupier when he is not looking."

Reformed Gambler | Canberra - April 28, 2010, 5:58PM

Read also:
Behavioral Finance: Key Concepts - Gambler's Fallacy

Eliminate or severely limit your investments in companies with large downside risks to avoid huge losses

When you think that there is a large downside risk in investing in a company, you should be especially vigilant even if expected returns are high.

• A highly leveraged balance sheet is one indicator of high downside risk in a company.  

• Even countries that borrow large amounts of money are not safe:   Russia defaulted on its loans in 1998.

Since even a country the size of Russia can get into trouble, clearly you should never think of any country as "too big to fail."

By eliminating or severely limiting your investments in companies with large downside risks, you should be able to avoid the huge losses emanating from market volatility.

On the other hand, market volatility may cause good companies' stock prices to go down in the short run, giving you good buying opportunities.

Limiting portfolio risk to extreme "black swan" events.

I am not looking for a systematic way to call market tops or bubbles, I don’t think they exist.

I am far more interested in finding ways to limit the exposure on the downside of a portfolio due to “black swan” events. The expression made famous by Nicholas Taleeb in his book The Black Swan. Such events would be defined as

• unlikely events with disastrous circumstances,
• bursting of bubbles, or
• other low probability events that could have disastrous consequences on a portfolio.

Also,  such thing as a perfect hedge that protects the downside and retains the potential for upside gains… is either non-existing or very rare.

http://seekingalpha.com/article/185531-in-search-of-the-illusive-black-swan-hedge-one-idea-worth-trying

Buy and Hold vs. Market Timing: Some personal observations

Short term traders do not hold their stocks for too long.  They often take their profit.  They then plough them back into another new trade when they perceive the upside is better than the downside.  They are not the buy and hold types.  To them, rightly so, buy and hold is a very dangerous strategy, especially so too if they are not picking carefully the stocks they trade in.   Short term trends are totally unpredictable.  They react to graphs depicting volumes and prices; searching for and attributing meanings to these.

When the market is on the uptrend, everyone benefits.  Postings were similarly optimistic.  "Why I like stock XXX?"  "Why I like stock XYZ, very much?"... Blah. Blah. Blah.   Now that the market has shown some volatilites and uncertainties, the postings turned pessimistic.  "Beware the black swan..."  Blah. Blah. Blah.  Such thinking is typical of a market timer. 

Yet, the reality is:  No one can predict the market with any certainty.  If he can, he will own the world.  But one should invest with some knowledge of the probabilities of likely outcomes. Even more importantly, is knowing the consequences arising from these probabilities, however unlikely these maybe.  Nassim Taleb is right to point these "fatal downsides" of unintelligent or emotional investing in his two classic books.

Let me share with you a "well known' secret.  Do you know that the richest persons  in the world are all mostly "buy and hold" type investors?  Look at the KLSE bourse.  Who owns the major wealth in the KLSE?  Lee family of KLK, Lim family of Genting, Yeoh family of YTL, Teh family of PBB, Lim family of TopGlove, Lee family of IOI, .......  They are the major shareholders of the good quality successful companies.  Do they buy and sell their shares in their companies regularly?  Do they make more of their money from trading their shares or from holding onto their shares over a very very long period?

Buy and hold is safe.  It is very safe for those with a long term investing horizon.  However, there is one provision:  You need to be in the right stock.  You will need to be a stock-picker.  Pick the good quality successful companies and you will have few reasons to sell them. 

Buy and hold is certainly very safe for selected stocks.  Do not react emotionally to price volatilities.  Price volatility is your friend to be taken advantage of:  giving you the opportunity to buy these companies at a bargain and to sell them if they are overpriced.  Often, the price is correct and fair, and you need not do anything.   For the super-rich whose wealth are locked in a "buy and hold" mode for umpteen years in their good quality successful companies, this strategy has benefitted them immensely.  If they can grow rich, so can you.  After all, you can be a co-owner in their companies.  Think about this and you may wish to follow them too, buying into their companies at fair or bargain prices.  For this, you will need to be rewired appropriately.