I thought of a few more. Taxes, fees, and penalties can cost you. Be especially careful about mutual funds, which can charge outrageous amounts in an attempt to keep you locked in. One can avoid a lot of taxes by using retirement accounts, but you really can’t take the other side of these deals.
Inflation is another big one. You’re not technically losing anything in nominal terms, but your buying power does shrink over time. The Fed’s 2% target is not such a big deal for one making 20%, but sometimes inflation is much higher.
Bear market risk is fairly easy to understand: a rapid selloff decreases the value of stocks you own; in which case one is better off holding cash or commodities. That’s left-tail risk. OTM puts are left-tail insurance.
Right-tail risk is less intuitive. After all, if your stocks rapidly appreciate, isn’t that a good thing? But a period of high inflation can also inflate stock prices, although the relationship is complicated (value stocks tend to do better, while growth stocks may be hurt by the economic effects of inflation by more than their prices inflate). Inflation is a Red Queen race: you have to run (in dollar terms) just to hold your position (in buying power terms). In a period of higher inflation, one has to run faster to keep up. OTM calls are right-tail insurance (there is also a sense in which they’re equivalent to a married put). Commodities (but not cash) can also be helpful here.
Even without high inflation, missing out on the right tail can mean being left behind compared to a non-dollar benchmark, like passive index investing. Hence the buy-and-hold adage about time in the market rather than timing the market. However, cutting off both tails would have done similarly well, at least historically. You can theoretically do that with a costless options collar, i.e., sell a covered call to fund an OTM (married) put, although IV skewness across strikes makes that less obviously a win as the downside has to be further OTM. Using (e.g.) VIX calls as insurance may be more efficient, but it’s also more complicated.
I thought of a few more. Taxes, fees, and penalties can cost you. Be especially careful about mutual funds, which can charge outrageous amounts in an attempt to keep you locked in. One can avoid a lot of taxes by using retirement accounts, but you really can’t take the other side of these deals.
Inflation is another big one. You’re not technically losing anything in nominal terms, but your buying power does shrink over time. The Fed’s 2% target is not such a big deal for one making 20%, but sometimes inflation is much higher.
Bear market risk is fairly easy to understand: a rapid selloff decreases the value of stocks you own; in which case one is better off holding cash or commodities. That’s left-tail risk. OTM puts are left-tail insurance.
Right-tail risk is less intuitive. After all, if your stocks rapidly appreciate, isn’t that a good thing? But a period of high inflation can also inflate stock prices, although the relationship is complicated (value stocks tend to do better, while growth stocks may be hurt by the economic effects of inflation by more than their prices inflate). Inflation is a Red Queen race: you have to run (in dollar terms) just to hold your position (in buying power terms). In a period of higher inflation, one has to run faster to keep up. OTM calls are right-tail insurance (there is also a sense in which they’re equivalent to a married put). Commodities (but not cash) can also be helpful here.
Even without high inflation, missing out on the right tail can mean being left behind compared to a non-dollar benchmark, like passive index investing. Hence the buy-and-hold adage about time in the market rather than timing the market. However, cutting off both tails would have done similarly well, at least historically. You can theoretically do that with a costless options collar, i.e., sell a covered call to fund an OTM (married) put, although IV skewness across strikes makes that less obviously a win as the downside has to be further OTM. Using (e.g.) VIX calls as insurance may be more efficient, but it’s also more complicated.