The “Don’t Pass” Portfolio

On Thursday of last week, I had a bad day in my portfolio. Everything went wrong-way on me.

Why? Because President Trump intimated that he wasn’t going to attack Iran.

But… isn’t that a good thing?

Yes, and I am usually implicitly or explicitly betting on bad things to happen.

What? Yes, that’s right. I always have exposure to the tails.

Let me ask you a question. Let’s say something really bad happens somewhere in the world. Stupid example, but let’s say India and Pakistan nuke each other. How much do you think stocks go down on that? 25% conservatively, maybe up to 40%. Wouldn’t it be nice to not lose money if that happens? Wouldn’t it be nice to make money if that happens?

It is possible. Basically, you have to:

1. Be long gold

2. Be long bonds

3. Be short stocks

4. Be long volatility

5. Be long the dollar

6. Maybe be long oil and other commodities

Now, I’m not suggesting that you’re walking around with a short position in stocks all the time. That could be ruinous. And you could spend a lot of money trying to be long volatility because of the carry. You could buy options on all these things: call options on gold, call options on bonds (like in TLT), put options on stocks, call options on VIX (though I don’t recommend this). I’d reserve getting exposure to the dollar using derivatives to the pros, and you should have a basket of commodities anyway. This isn’t free, but it will help you sleep at night. 

I am writing this on Friday, January 16, and even though Trump said he wasn’t going to imminently bomb Iran, he might at some point in the near future. It is good to have exposure to the tails—this gives you an antifragile portfolio.

Anything Can Happen

Now, I’m not suggesting that Joe Shlabotnik who reads The Jared Dillian Letter go around getting tail-risk hedges on everything because that is probably beyond his financial acumen. But running around long a bunch of stocks with no hedge whatsoever is not a good idea either. If the S&P 500 returns 18% in a year, and you spend 3% hedging it—on hedges that turn out to be worthless—then you still made 15%, and you are pretty happy. Certainly happier than if you are completely unhedged and the market crashes, or something like that. 

Keep in mind that Trump is president, and Trump is a high-volatility president—anything can happen. And the world is crazier than it ever has been, right? The idea of being completely unhedged is unappealing to me. In my personal investing, I have two accounts: a main account, with all the stuff I am long; and an options account, where I put all my hedges.

I lost about $100,000 in the hedge account last year. Money well spent. My gains in the main account with all the stocks I am long dwarfed that. And keep in mind that I wasn’t fully hedged—if the market crashed, I would have still lost some money. But I’d be much better off than if I was completely unhedged.

I’ve said this a million times before, but people buy insurance on their house and their car and their life, but they don’t buy insurance on their portfolio. Nuts! They have a $50,000 car and a $700,000 house and $6 million in a 401(k). No insurance on the 401(k). Blows my mind. I think one of the reasons people don’t do this is because their attitude about the stock market is easy come, easy go, and then they just assume that if the market goes down, it will come back. Well, shoot. Maybe it will and maybe it won’t. It didn’t come back in Iceland!

I call this building the “Don’t Pass” Portfolio. “Don’t Pass” is a term from craps. If you are playing the Don’t, you are basically betting against everyone else at the table, that the shooter is going to crap out and everyone is going to lose money except for you. If you’ve ever been at a craps table, you know that people dislike Don’t Pass bettors. You get heckled a lot. The odds are pretty much identical, but the Don’t is for people who like schadenfreude, taking pleasure in other people’s pain.

My wife knows me by now. If the market has a bad day, down about 2–3%, she’ll see me coming out of my office and say, “You had a good day today, didn’t you?” And I just nod. The Don’t Pass Portfolio.

Intentional Losers

I think one important concept to understand is that not every trade has to be a winner. After having written financial newsletters for 18 years, I can tell you that if I have a portfolio of 20 stocks, and 19 of them are winning and one of them is losing, people go into panic mode about the one losing trade (this is actually happening right now). 

If you do not have something in your portfolio that you hate, then you are not diversified. These put options that I am exhorting you to buy are intended to be losers. They are insurance. I have probably spent $200,000 in homeowners insurance in my life. Does that mean buying homeowners insurance was a bad idea? Absolutely not. That’s the way you have to think about it. You are setting money on fire so you can sleep at night. One of these days, Mr. Market is going to come along and say, “Nice portfolio. Shame if something happened to it.” If stocks go up, you will lose money on your puts and your shorts. There is no getting around it.

In my first newsletter of the year, I expressed a bearish opinion on the market. The market being what it is, those predictions will probably not come to pass. You should still hedge, especially when the cost of hedging is cheap, as it is now.

Jared Dillian, MFA