By now, everyone knows what a tail is. The concept has become rather ubiquitous, even to many for whom tails were considered inconsequential just over a few years ago. But do we really know one when we see one? In previous article we have done backtesting our strategy based on Modern Portfolio Theory with the Capital Asset Pricing Model. The strategy beats s&p, but as you can see there were a few big drawdowns despite the fact we have established risk tolerance equal to 10%. We see a large anomalous drop correlated with the benchmark. The biggest falls were in 2002 and 2008.Falling stocks in 2002. Falling stocks in 2008. Why does this happen? The measure of risk based on CAPM is fairly naive since it has been well documented that most, if not all, asset classes have non-normal, fat-tailed and often asymmetric return distributions. Asymmetric properties are not well accounted for in a mean-variance framework as they underestimate tail risk in negatively-skewed portfolios. Due to the principal-agent problem in the asset management industry, most money managers rationally have a propensity to use a negatively-skewed payoff distribution. This kind of behavior, in aggregate, is also evidenced in the historical data, which shows significant losses for professional investors during the largest market downturns. Most investors and asset allocators, in addition to these negatively-skewed positions, further view the returns of hedging strategies in a vacuum, rather than as a holistic part of their broader portfolio. Thus, they are likely to consider portfolio hedging programs to be a drag on their performance numbers and further undervalue them. We believe that these factors, among others, contribute to a market segmentation that creates an undervaluation in tail-risk hedges. Mark Spitznagel, Chief Investment Officer of Universa hedge fund which is advised by Nassim Taleb, believe that fat tail events can be predicted. His hedge fund was up 20% and netted about $1 billion in profits in August this year when the Volatility Index (VIX) hit its highest level in four years as markets got clobbered and the Dow collapsed 1,000 points in early trading. Mark Spitznagel uses the Q ratio as the most robust metric with which to recognize aggregate overvaluation in the stock market. This ratio is essentially the well known Tobin's Q ratio of Nobel Laureate James Tobin, which is the ratio of aggregate enterprise value to the aggregate corporate assets or invested capital; more specific to equity investors is the equity Q ratio, which is total equity over the net worth of the firm (where total assets are netted against total debt, so with no debt the net worth is the invested capital). Where IC is total tangible invested capital. Here is the annual history of the Q ratio from the most current all the way back to 1900, which is as far back as we can go. The reader will notice that, while the Q ratio has clearly been mean reverting, the arithmetic mean to which it has been seemingly attracted is, surprisingly, not 1, but rather about .7 Where the price equals the net worth of the businesses, Q=1. The current value of invested capital has been systematically overstated (and its depreciation understated). The Q ratio today is approximately 1.04. As is clear in the chart, this number is exceedingly high historically. This would imply that the U.S. equity market is today quite overvalued. The question for the remainder of this paper is: What does this mean for the equity investor? Businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption/investment proportion is reestablished, and business investments in the higher orders are seen to have been wasteful - Rothbard, Murray, American's Great Depression High Q periods are periods of “wasteful malinvestment,” and “the adjustment process consists in rapid liquidation of the wasteful investments.” The question is not if, but when. And, in fact, though not surprisingly, the majority of the losses tend to happen in a rather concentrated plunge at the tail end of the path down to minus 20%. We believe that these factors, among others, contribute to a market segmentation that creates an undervaluation in tail-risk hedges. Assuming there are such opportunities in hedging tail risk, let's evaluate how one can depict an asset class's risk-return profile and see if using a fair proxy tail-risk hedging program could help us better maneuver these not-so-uncommon market crashes. Our tail-hedged portfolio consists of our stocks and out-of-the-money put options on the S&P 500 specifically one delta, which has a strike roughly 30-35% below spot. At the beginning of every calendar month, using actual option prices, the number of third-month options (with a maturity from 11 to 12 weeks, and also carrying over the payoff from unexpired options) is determined such that the tail-hedged portfolio breaks even for a down 20% move in the S&P 500 over a month. From practice, for scaling the payoff, we can safely assume that the S&P 500 optionsв implied volatility, or IVol, surface would look similar to the one observed after the lows of the October 2002 crash (an observed in-sample data point for the backtest period). Asymmetric profiles, as evidenced by the tail-hedged portfolio, significantly raise both the returns and the risk adjusted returns of equity portfolios, which should be deterministic in allowing one to capture much greater equity risk premium over time. Asset allocation decisions should be refined when analyzing asymmetric returns to include additional stress tests that identify potential portfolio tail risks and appraise their mitigation. Stay as far from the middle as possible.Nassim Taleb's investment strategy is to put 90% of the money in the stable securities and the remaining 10% in a large number of high-risk ventures.We have selected high-growth technology companies with great financial strength for our portfolio. 90% of our portfolio will consist these stocks and 10% out-of-the-money put options on the S&P 500 (specifically one delta which has a strike roughly 30-35% below spot). This insulates us from bad black swans and exposes to the possibility of good ones. The smallest investment could go convex explode. And fundamental analysis of our companies shows that stock prices will rise in prosperous times.