“Investing and speculating are widely confused. Investing is “to allocate capital into productive activities with the anticipation of operating profit.” Speculation is “to allocate capital in order to profit from politically caused distortions in the market place.”

If you can think of any counter-examples, please let us know!

The new assumptions present a far different picture of risk. Consider the 60% stock, 40% bond portfolio that fell about 20% last year. Under the fat-tailed distribution now used in Ibbotson’s tool, that should occur once every 40 years, not once every 111 years as assumed under a bell-curve-type distribution. (The last year as bad as 2008 was 1931.)

Insulation from extreme market events doesn’t come cheap. Allianz SE’s Pacific Investment Management Co., or Pimco, which systematically hedges against extreme market events in several mutual funds launched last year, says the hedges may cost investors 0.5% to 1% of fund assets a year. Pimco uses a variety of derivatives and other strategies to hedge the funds.

You can read the whole article here: ( “Some Funds Stop Grading on the Curve”, 8 SEPT 09 ).

In many ways, this new approach to portfolio optimization incorporates the barkings of Nassim Taleb, of Black Swan fame, who has been incessantly warning of the dangers of designing portfolios assuming the “thin” tails of the Gaussian probability density, rather than using a more realistic “fat tail” model. Fat tails more accurately, and usefully, account for extreme bad outcomes, such as we recently experienced in the credit and real estate markets.

We expect in one to two years the large investment and broker-dealer firms will routinely offer Fat Tail-based portfolio design as well as special mutual funds incorporating these ideas.

Finally,  as we noted in our post of 15 JULY 09, this knowledge has been available for 20 years. So it is quite stunning that the financial industry, which usually is amazingly fast to adopt good ideas, has avoided the fat tail approach until now.

We draw your attention to very useful and well established type of security, the Structured Note (SN). (We emphasize SNs are not the Structured Investment Vehicle of recent ill repute.)  Their fundamental purpose is to provide an investment that focuses on a specific set of investment goals, market beliefs and risk preferences of the investor. These notes can provide diversification for all kinds of portfolios. They can deliver a chosen combination of bond, equity and options behavior, and they are customized and offered by financial institutions. Even better, you can design and implement many of the characteristics of these notes for yourself…or your RIA can do so.

The main characteristics of structured notes are:

1. A defined maturity date, upon which the note expires and the positions are closed.
2. Specified amounts of principal can be placed at risk, from 0% (“Principal Protected”) to over 100% (“Principal at Risk”)

These SNs are effectively a hedge fund style investment, without the fund. They are unlike ETFs and mutual funds for the two reasons above.

Simple Example of a Structured Note Designed at Home

Here’s a very simple example to get you started conceptually: A Principal Protected Note. (The numbers are intended to illustrate the concepts. Scales and other details are readily accounted for in practice).

Suppose you believe the S&P500 will appreciate in a year, but you are worried about Black Swans flying into your portfolio. You want to invest, but you are a bit anxious. How can you gain some upside and not risk much downside?

The idea is to build the note based on existing securities with required properties to get the desired behavior. Suppose you buy a zero coupon bond (ZCB) from the US Treasury and the ZCB has 1 year maturity and $10000 par value. Let’s say you pay $9800 now and the UST will pay you $10000 one year from from now for a 2% ZCB.  In 1 year, you will get your principal paid back with a $200 profit. What if you invested that $200 due to you in one year, now? In effect, you will spend your future guaranteed profit on the possibility you can make more money in a year through investing.

For example, do this: put the $200 in a money market account. Then buy an out-of-the-money call option on the S&P500 Index. In one year, there are two possibilities:  the option will be worth nothing, in which case you have only the money market remainder if any, or the option will have some profit in addition to any money market remainder.

Worst case, you lose the full $200. But you get the $10000 payoff, $200 of which matches what you risked on the option initially. So your $9800 principal is repaid.

Extensions of the Basic C0ncept to More Complex Structured Notes

You can extend the maturity of the ZCB and the type of option or stock position (purchases, spreads and straddles,…). You can choose other types of very high quality bonds. For example, if the ZCB above had a maturity of 20 years and paid 4%, then the initial purchase would be $4564 and you would get back $10000 at 20 years. So you would have $5436 to invest in some other position. Again, you could lose the entire $5436 and still regain your initial capital in 20 years.

Of course, this form of principal protection is simplistic since the time value of the money is lost. But the main idea holds.

These basic concepts can be developed by your investment advisor to target your specific investment beliefs, and they offer good diversification possibilities.

Live it up, be a hedge fund manager!