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Alternative Market Briefing

Other Voices: How hedge funds can reduce tail risk during a market sell-off

Tuesday, February 06, 2018

On Friday the Dow Jones Industrial average fell 665 points causing many investors to wonder if the 9 year bull market has come to an end. History has proven that most investors are terrible at predicting the direction of the market. To do so successfully requires two correct decisions: when to get out and when to get back in. Investors' emotions often drive their investment decisions. As a result, they typically buy near market peaks and exit near market bottoms.

Major corrections in the capital markets are a risk that investors must always consider. Experience shows the question is not if a major correction will happen, but when.

Events of the past couple of decades have led investors to expect markets to rebound quickly from a major correction. Seemingly forgotten is the worst sell-off of the US stock market, which began in 1929 and resulted in a decline of almost 90%. It took 23 years to recover. For those tempted to dismiss this as outdated data, take note that the Nikkei index hit an all-time high of approximately 39,000 in 1989. 28 years later it is still approximately 40% below its all-time peak.

Instead of trying to time the market, investors should construct a diversified portfolio that can withstand market turbulence thereby avoiding the need to sell at market bottoms. Unfortunately most investors significantly underestimate the "tail risk" of their portfolios.

When building out a diversified portfolio, investors seek to maximize risk-a......................

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