In his book The Dao of Capital, Mark Spitznagel lays out a simple approach to tail hedging. This is the same approach that he uses at his investment firm, Universa Investments. The fund generated a 3,612 percent return in March 2020, when markets dropped dramatically due to coronavirus fears (source).

I’ll quickly lay out why this is important and then describe how to do it.

***

There are many reasons to believe all markets are too richly valued.

Here are three views that show that.

1. MS Index and Tobin’s Q: Spitznagel looks at what he calls the Mises Stationarity Index (MS Index), which is a rough measure of market prices for assets relative to the book value of those assets.

Source

The MS Index is similar to another metric called Tobin’s Q, and this is what that index has looked like since 1900 (source):

2. Shiller PE ratio: There’s another metric, the cyclically adjusted price to earnings ratio created by the economist Robert Shiller, that compares the price of equities to cyclically adjusted earnings. Here’s that ratio over time (source):

3. The Buffett Indicator

Warren Buffett has an indicator he likes to use, which is the ratio of the total value of the US stock market to the US GDP.

Here’s what that looks like as of August 20, 2020 (source):

***

One of the major drivers of inflated prices is the action of central banks in all major economies. Here’s a view into just how extraordinary their support for markets has been (source):

***

You buy insurance for your car, your house, and your life. It seems only reasonable that you should buy insurance for your investment portfolio, particularly if you believe there is a heightened risk of dramatic corrections.

Here’s how you can buy that insurance, per Mark Spitznagel:

The portfolio I am testing in this study purchases 2-month 0.5 delta puts on the S&P Composite Index at the start of each strategy period at an assumed 40 percent starting volatility level (which is a historical median pricing level—and, in fact, within a large range, the return outperformance levels reported are surprisingly robust to this pricing level). After every month, the 2-month put options position is rolled (the existing options are sold and new 2-month puts are purchased, which resets the position every month). A historical, conservative interpolated mapping is utilized, which maps monthly index returns into concurrent monthly changes in pricing (or implied volatility) of the 2-month puts (for monthly vega profit and loss), as well as changes in the pricing spread between 1-month and 2-month puts (for monthly rolling). This mapping allows the test to include time periods before data are even available for options markets, thus providing a much greater range of market environments. Each month the portfolio spends one half of one percent on puts, and the remaining 99.5 percent stays invested in the S&P index. No leverage is employed (and, in fact, typically when the market is down by not even 20 percent the entire portfolio is actually net profitable).

More practically, here’s how I executed this:

I used Robinhood, upgrading my account for basic options trading.
I calculated how much I need in options: 0.5% x my portfolio. For illustrative purposes, let’s say that’s $10,000.
I’m going to buy put options on the popular S&P 500 ETF SPY, which at the time of this writing is about $300.
We want options that are 30 percent out of the money, so that means buying options with a strike price of $210.
Looking on Robinhood, the closest date two months out is August 21, 2020. The price to buy put options at a $210 strike price for that date is $1.59 per share.

Each contract is 100 shares. So the price of one contract is $159 ($1.59 x 10).
So for $10,000 of coverage, you need 63 contracts ($10,000 / $159).
Buy 63 contracts.
Set a reminder to roll these every month, meaning: every month, sell the contracts you have at the prevailing price and do the same thing again.
In the extreme case, you lose 6 percent a year, but more likely, it will be something less than that, as there will be some down months in that year and periods of increased volatility. And there’s some small chance of a very large downturn, in which case the options will pay off by multiples of their value if not tens of multiples, allowing you to reinvest that return into the market at attractive prices.