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White paper — Hope for the Best and Prepare for the Worst

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Swan Research — Innovative Thought Leadership

Although we are many years removed from the depths of the finan­cial cri­sis of 2007-08, investors remain jus­ti­fi­ably scarred by the calami­ty. How­ev­er, the pas­sage of time also offers the oppor­tu­ni­ty to assess what went wrong and how to avoid repeat­ing past mis­takes.

Many investors thought they were well posi­tioned by fol­low­ing the rules wide­ly preached through­out the finan­cial indus­try pri­or to the cri­sis. In an effort to min­i­mize risks, they invest­ed in port­fo­lios diver­si­fied across asset class­es and styles. How­ev­er, when mar­kets start­ed to unrav­el in 2008, the scope and sever­i­ty of the loss­es were much worse than what most peo­ple antic­i­pat­ed under their worst-case sce­nar­io pro­jec­tions.

The caus­es and blame for the finan­cial cri­sis and sub­se­quent Great Reces­sion have been hot­ly debat­ed and lie beyond the realm of this paper. The intent of this paper is to address the mis­con­cep­tions and mis­steps that intel­li­gent, ratio­nal investors made pri­or to the cri­sis and that result­ed in sig­nif­i­cant loss­es of wealth. Three mis­con­cep­tions stand out:

  1. Extreme mar­ket cor­rec­tions, or “black swans”, are rare and hap­pen with­in a pre­dictable lev­el of (in)frequency
  2. A well-diver­si­fied port­fo­lio is the best way to min­i­mize risk
  3. Risk is defined as volatil­i­ty

This paper clos­es with a descrip­tion of the Swan Defined Risk Strat­e­gy, which was designed to address all three of the­se fatal flaws.

The Swan Defined Risk Strat­e­gy was designed to address the three fatal flaws in main­stream port­fo­lio think­ing. Rec­og­niz­ing that: 1)trau­mat­ic events do occur with alarm­ing fre­quen­cy; 2) tru­ly dif­fer­ent type of return is need­ed to diver­si­fy risk; and 3) risk should not be sole­ly defined by volatil­i­ty, the Swan Defined Risk Strat­e­gy was built to provide cap­i­tal preser­va­tion dur­ing peri­ods of mar­ket tur­moil. In addi­tion, the Swan’s Defined Risk Strat­e­gy was designed to cap­ture a good por­tion of up mar­kets as well.

There is also an exec­u­tive sum­ma­ry ver­sion of this paper avail­able as well.