As the year 2011 draws to a close, I wanted to briefly reflect on the past year and share some thoughts going into 2012.

Twenty-eleven was an eventful year for investors, as we witnessed everything from the Arab Spring uprisings, to a tumultuous summer of debt ceiling debates and credit downgrades, to the continuation of the euro crisis and deterioration of several European countries' finances.  All of these significant, large-scale crises/events should serve to remind us that black swan-style events are more common, and even less predictable, than we may allow ourselves to think, as we seek and crave stability for our financial portfolios.  At the risk of sounding clichéd, we must expect the unexpected.

Twenty-twelve will be no less eventful, considering that the following lies ahead:

1) Presidential election (remember what happened in the 2 months prior to the last one?)

2) Increasing waves of foreclosures in the housing market as Option ARM and Alt-A mortgage rates reset to higher levels

3) Unsettled financial outlook for more European countries that have yet to come into the spotlight (i.e., Spain, France)

4) Congress' continued ineffectiveness at reducing the national debt, cutting spending, or even just passing a budget

5) Possibility of further downgrades to the US credit rating (largely due to item #4 above)

I hesitated to even list these things, as it may come across as forecasting, and we know that doing so is too often a fool's errand -- but I put the list there to simply remind you of the very tip of the iceberg that we can even BEGIN to try to anticipate, all the while knowing that none of these things is guaranteed to come to pass (except #1 and probably #4) and could easily be replaced by other bad news.

While I don't tend to make New Year's resolutions, I do have every intention of maturing and refining my black swan protection protocols for 2012.  I think the stakes for having them in place will be higher than ever, and I'd like to create opportunities to generate some profits as market turbulence occurs.  (Notably, 2011 was the fourth-highest year for 100-point swings [plus or minus] in the market, behind 2000, 2002, and 2008.  I see no reason why 2012 won't compete with these other years.)  I'll be focusing a bit more here on the blog on options strategies and combinations that I plan to experiment with or at least consider in 2012.

Along those lines, I encourage you as the individual investor to commit to a regular schedule or routine of reviewing and closely scrutinizing your portfolios amidst the uncertainty that we're facing.  Set aside some time as frequently as monthly, for example, to check the kinds of holdings you have and what their exposures are to which kinds of risks.  Compare this to what you see and hear in the news regarding government inaction and recklessness, global/market instability, geopolitical pressures, and so forth, and make the best attempt to align yourself defensively towards these risks, while looking for opportunities to benefit where possible and generate profits.  Of course, if you utilize a financial advisor, communicate these objectives and concerns to him or her and ensure they are being addressed.  (While none of what I write is intended as investment advice, I consider the above a common sense approach to investing that any of us could stand to employ.)

Lastly, I want to issue a simple "thank you" to all of the readers and contributors to this site, as I greatly appreciate your interest and passion for this subject.  I wish all of you a safe and prosperous 2012.

Seventy years ago on this day, Japanese armed forces attacked the US naval base at Pearl Harbor, effectively marking the beginning of the United States' direct involvement in World War II.  While we take today to remember this historic and tragic event, I would now submit to you that our country will soon face another Pearl harbor-style event, but this time of the financial sort.

Put another way, we are up against the ever-increasing possibility that our country will suffer a crippling blow financially, with an impact not unlike the Pearl Harbor events of 1941.  The biggest difference may lie in the fact that our country recovered from the Pearl Harbor attack and emerged stronger, something I do not expect will happen now given the dire state of our nation's finances.

A quick summary/reminder of what we're up against:

1) A national debt that now exceeds $15 trillion.  We are paying approximately 3-4% interest on this every year, equating to interest payments of no less than $450 billion.  Servicing this debt will increasingly weigh upon our economy, and force future generations to work harder for less as we struggle to pay the interest alone, nevermind the actual principal.

2) Routine budget deficits totaling over $1 trillion a year, adding to the aforementioned debt.  Our government has promised us way more than they can deliver, and this is evidenced by the fact that every year our budget contains more spending than what we are taking in as a nation.  This is called "living beyond our means."  It's destructive, adds to the national debt, and must stop immediately.  Cessation of deficit spending means we will get less from our government for the same price for a while, but we need to accept that privation and stop selfishly pushing it onto our children and grandchildren.

3) Potential for further credit downgrades, increasing the cost of our borrowing needs.  S&P recently knocked the US credit rating down a notch, resulting in market turmoil, but curiously had no effect on our cost of borrowing.  That won't last forever -- as future downgrades are made, which we know they will be given our government's inaction on this crisis, it will eventually catch up to us and the interest we pay on our debt will go up. This means more of our country's wealth will be needed to make those interest payments, rather than being used for more productive means.

4) Economic productivity that hinges on consumer spending, to the tune of over 70%.  This is unsustainable, simply put.  When almost three-quarters of a nations' economic production is tied to consumers spending their income or going deeper into debt, a day of reckoning lies ahead.  We need to get back to producing exportable goods (read: manufacturing) and making the country more business-friendly, as opposed to forcing those businesses to move their operations overseas.  The obvious question here is, what happens when Americans are so strapped they can't spend anymore?  You guessed it -- the economy goes in the tank.

5) Dwindling job market that practically guarantees lower productivity from a GDP standpoint, declining tax receipts, and a lower standard of living for the American people.  The persistent 8-9% unemployment (and 16+% underemployment) rate says it all -- jobs have left the country and they aren't coming back anytime soon.  This reality has a severe ripple effect, since unemployed people pay less (or no) taxes, spend less money, add less (or nothing) to the nation's economic productivity, which leads to economic slowdown, which leads to more job losses, and so on...you get the picture.

If you listened to my November 27 podcast, you'll recall me saying that our political leadership will not address this financial crisis until it becomes a full-blown catastrophe, as they will then have the political cover to get away with any law or policy they wish to see instituted.  The September 11, 2001 attacks provide the best evidence of this impotent style of leadership, as Congress only passed the PATRIOT Act (albeit a draconian, liberty-killing law in and of itself) AFTER the Twin Towers and Pentagon had been struck, and Flight 93 had been downed -- not before.

Thus, you as an individual investor have to factor into your financial planning the fact that the government will allow this situation to reach catastrophic proportions before acting.  Creating some degree of defensiveness against everything from high inflation, dollar weakness/collapse, and a plummeting stock market would be a minimum level of prudence for today's investor.

Another month, another one of the PIIGS makes headlines for its impending financial meltdown.  (PIIGS stands for: Portugal, Italy, Ireland, Greece, Spain.)  This time it’s Italy, bumping Greece out of the news for the meantime.  The problem is, Italy’s situation is far more dire when viewed through the lens of the global economy.  The fact that Italy is Europe’s third largest economy alone would account for that fact, without even factoring in the growing strain all of these recent bailouts have placed on the EU.

Let’s back up for a second and see how we got here.

In general, the entire PIIGS crisis can be summed up with the following statement: the countries in question borrowed more money than they were making.  In slightly more technical terms, they borrowed too much relative to their Gross Domestic Product (GDP), to the extent that they are now unable (or having serious difficulty) meeting their fiscal obligations.

How did Italy get into this mess, specifically?  This article, titled “Italy’s Debt Crisis: Doomed by Corruption, Bloated Bureaucracy and Poor Productivity,” is a good primer on the basic reasons, and I’ll attempt to sum them up here:

1) First and foremost, perhaps as the general and foundational reason behind Italy’s woes, is the fact that it’s overspent by 1.9 trillion euro, or 120% of GDP.  

2) Corruption is widespread, with Italy’s Mafia accounting for nearly 16% of GDP.  (Obviously, this economic output isn’t necessarily optimized to aid the country’s growth.)  Tax evasion isn’t just limited to the criminals, as ordinary citizens have seemingly embraced it as a national pastime.

3) Bloated bureaucracy is an enormous cost unto itself.  Italy’s politicians earn 140,000 euro a year on average, and are driven around in executive cars (Audis, Maseratis, etc.) that cost the country 2 billion euro a year.

4) Italy’s education system is extremely poor, with only one of the world’s top 200 universities located in Italy (University of Bologna).  To underscore this, Italy’s unemployment rate for youth between the ages of 15 and 24 is a staggering 30%.

As you can see, many of Italy’s problems are systemic, and have gradually led the country into a worsening position financially.  The irresponsible government spending is really only the tip of the iceberg.

So where do things stand as of today?  Italy’s borrowing costs have rapidly increased over the last several weeks, hovering around 7% as of the writing of this article.  These government bond yields are a good yardstick for determining how unstable things have become, and it’s interesting to note that the other three EU nations that required bailouts (Greece, Portugal, Ireland) had also reached the pivotal 7% mark when they received emergency assistance.  These higher yields reflect investors' declining confidence that Italy can and will repay the debt.  Thus, they are seeking a higher premium for taking the risk of buying these bonds.

The outlook for Italian citizens is grim.  This past weekend, austerity measures were proposed that would result in a familiar combination of remedies -- spending cuts and tax increases – with the goal of balancing the budget by 2014.  Expect Italians to vehemently protest these measures.

External to Italy, I expect things to worsen significantly as we head into 2012.  The previous bailouts of EU nations have cost billions, and ultimately have done little to stem this contagion.  How much more money will the EU have to conjure up (read: print) in order to save Italy?  Not to mention the possibility of Spain and other countries requiring similar assistance in the near term.  

I cannot understate the severity of the aftershocks the collapse of Italy would cause for both the global economy and the US in particular.

Let’s walk through a possible vignette on how things could get ugly quickly if Italy goes down (keep in mind, this is a highly simplified example, and only one of many possibilities that could arise):  Italian bonds are bought and held by a wide variety of institutions around the world.  Let’s assume a host of Italian banks hold these bonds, and are informed by the Italian government that many of them will either only be paid back to a partial extent, or perhaps not paid back at all.  Several of these Italian banks would then presumably go insolvent, especially if they have high exposure to the bonds.  The same goes for other EU banks holding those bonds, as well as EU banks that had other types of holdings with the Italian banks that are suddenly failing.  Several of these EU banks would then go under, as well.  Here in the US, banks holding Italian debt, and/or invested in any way in the Italian and/or EU banks that are going insolvent, would also be subjected to potential insolvency.  As the EU collectively attempted to inject monetary assistance into the system, the very stress that cost would create would likely exacerbate the matter and trigger even more bank failures, insolvencies, and related bankruptcies. 

In other words, an enormous chain reaction would be set off.  If you think of the global economy as a massive series of interconnected/interdependent nodes, then you can begin to envision how the failure of several of those nodes begins to propagate negative consequences across the entire network.

This scenario would not be pretty for your investment portfolio.  Recent market perturbations and EU/PIIGS anxiety have already spooked the average investor, and this is just a taste of what’s to come.  Now is the time to review your portfolio and determine how much exposure you have to the kinds of systemic risks I’ve discussed here.  Gauge how high your risk tolerance is and then make defensive adjustments as necessary.  If you have extra cash, you might also consider betting that a collapse will occur, and invest in options or other high leverage instruments.  

I thought that title might get your attention.  Sounds pretty outlandish doesn’t it?  Well, this post is about the individual who experienced a 67,000% gain in a matter of days back during the 1987 stock market crash.

His name is Nassim Taleb, and I’ve written about him and his philosophies extensively on this blog.  I’ve read quite a bit of material by Taleb, in particular his best selling books like The Black Swan: The Impact of the Highly Improbable and Fooled by Randomness, but not until recently had I come across Taleb speaking in depth on his actual options trading strategies.  This article from The Forex Village contains some rare insight by Taleb on how he approached options trading.

Of all the information in the article, I think one of the biggest takeaways is Taleb’s point about how far out-of-the-money (OTM) options are likely not to be priced accurately.  Human beings created the option pricing formula.  Human beings have a very difficult time perceiving the likelihood of rare (and often catastrophic) events.  Thus, the option pricing formula does not perform so well when assigning values to far OTM options, since these options are attempting to capture the possibility of extremely rare events.  Ultimately, this undervaluing creates the potential for massive gains, like the one Taleb had in 1987.  

Simply put, the sizable gains that far OTM options can yield are staggering.  Going back to Taleb’s 67,000% gain (which resulted from him holding options on eurodollars and the deutschemark), it helps to put it in real terms:

Say you had a portfolio that totaled $1 million in value.  You decided to allocate 10% of that, or $100,000, to the kinds of far OTM options that Taleb held in 1987.  Where you began with $100,000, after the smoke cleared you’d be holding $67,000,000 ($100,000 * 670).  (Of course, this assumes you invest the entire amount at once and it hits that same month.)

That’s $67,000,000 -- off of a $100,000 investment.  This is far from typical in terms of the kind of result you can expect -- but that doesn’t matter.  It doesn’t have to be typical.  It only has to happen once.

It took a while to get around to writing this post.  I've been beating myself up, languishing in my recent error with respect to the stock market.  Simply put, I missed out on a gargantuan profit during the intense market volatility last week.  I missed a 1380% gain.

Yes, you read that right.  I could have multiplied my initial investment by 13.8.  Theoretically, I could have turned $1,000 into $13,800.

I’m repeating it this way more so for my own benefit, so I can stew in the knowledge that I abandoned the very system that I tout here on this blog in order to secure a short term gain instead.  Let me explain what I mean.

The week of July 25, I decided I wanted to buy the September puts on SPY in order to protect against the upcoming debt ceiling default that loomed over the US on or about August 2.  SPY was right around 130, and so I bought the Sep 119 puts against it.  When I bought them, the contract was selling for $0.65.

That Friday, July 29, those options had roughly doubled, and hence, I’d doubled my money.  I thought about whether I should keep the options in place despite this 200% move, since after all, black swan protection protocol dictates that I maintain my position throughout whatever black swan event might occur, and thus be able to capture the sizable move that would ensue.  After some contemplation, I decided 200% was enough -- I didn’t want to get greedy, and I figured the debt ceiling debate would be peaceably concluded over the weekend, in time to calm the markets the following week.

Just the opposite happened.  For whatever reason -- and it probably was a combination of poor US economic data, Europe’s financial unrest, and the threat (then reality) of the S&P credit downgrade -- the markets did the exact opposite.  Over the next two calendar weeks, we saw three large triple digit down days.  And that’s when my SPY puts went through the roof.

I remember looking on Monday, August 8, the first trading day after the credit downgrade, at the price of those options I’d held.  I honestly can’t recall the exact price at the time, nor do I know just how high it got that day, but suffice it to say that at some point I took the contract price and calculated how much I would have gained had I held on till that moment -- and it was 1380%.  The option I’d bought at $0.65/contract was now over $9 a contract.

What went wrong?  The bottom line is I didn’t implement a true black swan protection protocol.  I was simply trading options, nothing more than that.  In fact, I’d written here before about how I was going to start trying my hand at turning my options over for quick profits, rather than only maintaining the more defensive protocol of keeping them until expiration.  While it wasn’t wrong per se for me to choose this approach, it highlighted the benefits of always having that protocol in place for insurance purposes, regardless of what other trading strategies I might employ.

Truth be told, it’s difficult to employ the protocol month in and month out while losing money nearly every time, waiting for that one instance where the approach pays off.  And quite frankly, it may not make monetary sense either, when you look at all of the expired options you lost money on, versus the amount you make on one big move like last week.  In the end, you might still have a net loss for the year, even after catching a 1380% jump like I could have. 

In order to avoid that fate, you essentially have to go to the farther end of the “tail” so to speak -- the “tail” being the very far, flat end of the traditional bell curve, which represents the likelihood of a given event -- with your options purchases.  By this I mean, the further out of the money your options purchase is, the cheaper the contract will be, which equates to less money wagered and (most likely), lost.  However, when extreme volatility hits like it did earlier this month, even your far out of the money options will likely experience a significant bounce, absorbing your previous losses and netting you gains.  So what’s the downside to this approach?  Those far out of the money options won’t jump as much on smaller market movements, and so they’ll almost invariably expire worthless in every case.  Conversely, the closer in the money you are, the more chance you have of getting at least some kind of movement at some point in time...but you have to be willing to spend more for those options.

I’ll close by saying that if you want to institute a true black swan protocol, first make up your mind that the expense is just another line item in your budget -- call it “market insurance.”  Like all other insurances you pay for, consider it a sunk cost that buys you peace of mind.  Then select options as far out of the money as you can tolerate, and buy them robotically.  Then in the meantime, you can more actively trade options closer to the money if you’re so inclined.

If you’re currently using black swan protocols, I’d love to hear feedback from you on your approach and how it’s working out for you.

Before you read this post, read this article here.

So the question is, did you end up like the turkey over these last two weeks or so?

It's really incredible when you step back a moment and look at what the market has done since late July.  Consider the following:

-- Starting July 22 (a Friday) through today (August 11), the Dow Jones has gone down 11 of the 15 trading days in that time frame.

-- The Dow has declined 12.5% since July 21's point (12,724) to today (11,143).  Whether the market can hang on to today's sizable gains (+412) remains to be seen in this volatile environment, so we could easily head lower than 11,143.

-- In the last 15 trading days, we've seen three days of triple digit declines: Aug 4 (-513), Aug 8 (-635), and Aug 10 (-520).  Experiencing even one of these kinds of days would be considered a rare event, much less three in a span of five trading days.

Many people went into July 22 thinking they had a "conservative" or "moderate risk" portfolio.  After 12.5% (or higher) losses, many of those same individuals now realize they had high risk portfolios all along.  The problem is, no one told them that when their portfolios were constructed.

Worse yet, a good number of these individuals were planning on living off of these investments within the next couple years.  Undoubtedly, those plans have now been delayed, perhaps for some time as the economy and markets struggle to find their footing.

Isn't it funny how the market can take 12.5%+ from your portfolio in a matter of a few days, but it never seems to put 12.5% into your portfolio in a matter of a few days?  Of course, I'm sure you've heard it a million times before, but it bears repeating: once you lose 12.5% you have to make back an even greater percentage just to get back to even.  This often equates to needing a couple of years to earn back what's lost in a couple of days.  To me, that sounds like a very high risk proposition.

This is exactly why Nassim Taleb, author of the "The Black Swan: The Impact of the Highly Improbable" advocates a "barbell strategy" approach for the individual investor's portfolio.  In short, instead of trying to construct a medium risk or conservative portfolio, one should split their assets into an 80/20 allocation: 80% in extremely safe (relatively speaking) instruments like CDs, money markets, or cash; and 20% in very high risk investments such as options (or other securities that have a high payoff potential).  Of course, this 80/20 mix can be tailored for what fits you best, but the general principle remains the same.

Again, think of the markets the way the turkey should think of Thanksgiving.  Given that premise, if you have any flexibility at all, take a closer look at how you can construct a portfolio that is more robust to these market fluctuations and perhaps even benefits from them.  Click on the Black Swan or Nassim Taleb categories in the right hand column to read more about this subject.

“Printing money doesn’t deliver a triple-A rating.” -- David Beers, S&P Head of Sovereign Ratings

So the inevitable finally occurred this weekend -- Standard & Poor’s (S&P), one of the the three major credit rating agencies, downgraded the United States’ AAA rating to AA+.  Since the decision was announced, there’s been much wailing and gnashing of teeth at the audacity of S&P for insinuating the US should no longer hold the highest rating possible.  “How dare they” has pretty much been the refrain the last couple of days.

I say, what took them so long?  I mean, let’s face it -- the long term fiscal outlook for the US is awful, simply put.  Consider the following:

-- There’s virtually zero chance the US will ever pay back a single dime on the principal it owes on the national debt.  If I told you I had a couple of credit cards, I max them out all the time, and I never do anything but make the minimum interest payments every month and never pay into the balance, how eager would you be to lend money to me?  Probably not so much.

-- The US has $14 trillion of debt today, but this doesn’t take into account the trillions more coming due at the end of this decade and beyond for all the entitlement programs (Medicare, Medicaid, Social Security).  (I’ve read everything from approximately $50 trillion to over $200 trillion as the total cost of these programs.)  If the Congress and President can barely agree on how to cut $2 trillion (as part of the debt ceiling deal), then what are the chances they can deal with these enormous long term debt obligations?

-- The US economy is headed in the wrong direction, and perhaps permanently so.  The option of growing our way out of the debt problem, by being more productive and increasing the nation’s Gross Domestic Product (GDP), is looking more and more like a pipe dream.  Job growth is stagnant, with nearly one out of every two unemployed persons out of work for six months or more, and the eventual need to raise taxes will stifle job growth even more as businesses retrench.  Since our “productivity” relies heavily on consumer spending, a slowing economy and more limited borrowing ability (as a result of the credit downgrade) will further hamper any rise in GDP.  As GDP remains level and debts rise, our overall debt-to-GDP ratio will soar, a key aspect of the S&P decision.

To back up for a second, it’s important to understand what S&P is actually rating.  The grade they assign indicates the likelihood that the entity issuing the debt will pay back the obligation. At the same time, the rating tells the debt purchaser how much risk it is assuming in the transaction.  So the rating is intended to synopsize the long-term debt outlook for the entity being rated.  As the rating declines, debt purchasers can demand higher yields (interest rates) on the debt in order to compensate for the higher risk associated with the debt issuer, thus making it costlier for the issuer to borrow money.

What does this all mean to us as individuals in the US economy?  Well, as the US government’s borrowing costs rise, banks will raise their interest rates commensurately to keep up with the trend.  When banks raise their rates, this will affect everything from mortgages, to school loans, credit cards, personal loans, car loans and so forth.  You will eventually pay more interest to borrow money compared to today.

The credit downgrade signifies a sad day in our country’s history.  Once a great economic power, we’re now left in a position where our debt instruments are no longer considered the safest available.  We held that status for 94 years (since 1917), and never held a rating below AAA -- until now.   Some will have the urge to blame this development on the President, or his predecessor, or this Congress -- but the bottom line is the problem has been fomented over numerous decades.  Only now are we seeing a symbolic representation of this decay in our fiscal position as a nation.

Unfortunately, it probably won’t stop here.  With our long term debt outlook deteriorating year over year, S&P has indicated more downgrades may be coming.  With our debt-to-GDP ratio  projected to hit 101% ten years from now, such a development would warrant another downgrade, this time to AA status.

The best advice I could give right now is to liquidate as much debt as possible, as quickly as possible (assuming you have any).  While the downgrade’s effects could take years, you won’t be able to time when those effects hit, so you need to be protected well in advance.  In addition, as always, review your portfolios for exposure to assets that would most likely be weakened by the downgrade, such as the US dollar and US Treasury bonds, and hedge or short (bet against) these positions appropriately.  Again, the effects won’t come overnight, so you have to decide when the timing works best for you and your particular situation.

What are your thoughts on the downgrade?  Please leave a comment below or contact me directly.

Nothing more, nothing less.  The ongoing debate in Congress about whether the debt ceiling should be raised or left at the present level of $14.3 trillion or so is in and of itself a waste of taxpayer money.  We all know the outcome, but for some reason we have to go through the motions of acting like our elected officials are going to actually do something about this problem.  The reality is, the debate will go on for as long as it possibly can (about another 10 weeks or so until the limit is breached), and then the ceiling will be raised.

(The debt ceiling, or limit, is established in law, and is the cap that the government puts on its borrowing level.  The limit currently stands at $14.3 trillion.  To date, standard procedure for Congress when reaching the debt ceiling is simply to raise it.  It’s like the limit on your credit card, only every time you reach it you just call your bank and they raise it some more, so you can keep on borrowing and spending.)

I’m saying it here, now, on May 26 on my blog -- there is a 100% chance the debt ceiling will be raised.  I don’t need to watch any news clips, review and analysis of Congress’ machinations, or anything of the sort.  It’s a done deal already, before we even arrive at the ceiling.

Why?  Because our country is addicted to debt/consumption/borrowing/spending.  We’re not going to stop spending.  The public demands it.  Congress needs it for reelection.  Our economy thrives off of it.  It will go on, until it can’t go on anymore.

One great piece of evidence of this fact is the recent discussion on the Paul Ryan (Republican representative from Wisconsin) budget plan, which included the controversial proposal of turning Medicare into a voucher program for individuals under age 55.  Generally speaking, this means that instead of the government picking up the tab for your medical bills, you’d be given a lump sum subsidy to allocate towards insurance coverage of your choosing.  My understanding is that if the subsidy didn’t cover the bill, you’d be left to pay the difference.  Of course, the phase-in for the under 55 crowd would theoretically allow for those individuals to make other arrangements to augment their Medicare subsidy, while those over 55 would still be covered under the old program as they’d have less (or no) time to adjust to the new program.

Say what you will about the Ryan proposal -- I don’t know it inside and out, and even then I can say that I’m sure it’s far from perfect.  But if it’s nothing else, it attempts to do what no other plan seems to be willing to do, and that is to make the hard choices necessary to change a program that simply can’t exist in its current form.  Medicare has to change -- the question is, do we change now and suffer the pain, or change later and incur even more misery as the problem morphs into a crisis.  (I say “change” and not “fix” because we can’t say whether the Ryan plan would actually fix the program. Unintended consequences of his plan could simply leave us with a new set of dilemmas to face, which is often the case whenever the government gets involved in anything.)

This week, the Senate voted on the Ryan plan and defeated it.

So we needn’t look any further than the Ryan plan to understand the spending addiction is too great, too deep-seated to be undone now.  As an individual investor, you should be planning for scenarios that include continued high levels of government borrowing and spending into the foreseeable future.  Commensurate with that, your planning would then include rising interest rates, a weakening dollar, rising commodity prices, and even eventual replacement of the dollar as the world’s reserve currency.

The one thing you don’t need to waste your time with is following the debt ceiling debate.  It’s theater, pure and simple.  Republicans, who appear to be holding fast to the notion that they’ll vote against a raise in the debt limit unless significant spending cuts are instituted, will ultimately bow to the political pressure associated with being responsible for cutting off the gravy train of spending and consumption.  Democrats will allege that Republicans want to cut off funding for critical social programs (such as Social Security and Medicare), and that’ll do the trick to derail any serious discussion on spending cuts and the debt ceiling.  

Mark your calendar for early August -- that’s when the debt ceiling will be raised.

So we were chugging along nicely, watching the Dow climb above 12,000, practically doubling in the last two years.  A recent headline on Yahoo.com declared the return of the average investor into the stock market with the following headline:

The Return of the Little Guy

Then, a few days after that proclamation, an 8.9 magnitude earthquake hit Japan and a tsunami resulted.  At one point on March 15, the Nikkei Japanese stock index had plunged nearly 13% during intraday trading.  Markets are still on edge as I write this due to the worsening nuclear plant situation at Fukushima.

Does that 13% number sound familiar?  Remember the May 6, 2010 “flash crash,” when the Dow plummeted 1,000 points intraday, losing a tenth or so of its value in a matter of minutes?  An intraday drop as large as the Nikkei experienced is incredible no matter how you look at it.  One way of doing so is to compare it to the October 1987 crash in the US stock market, which fell over 22% in one day.  The Nikkei was more than halfway there on March 15.  Incredible.

The moral?  Investors -- especially “the little guys” -- were caught off guard May 6, and most were caught off guard again on March 15.  

Both of these events fit the black swan conjecture.  They were surprises.  They were highly impactful.  After the fact, some felt the events were the kind that could have been anticipated or even predicted. 

But let’s look at things realistically.  A month ago, if someone had forecasted a 13% intraday drop in the Nikkei, or any stock index for that matter, the possibility would have been dismissed as highly unlikely if not impossible.  The individual would have been labeled “fatalistic” or a “doomsayer.”  But it is precisely this kind of hubris -- or the “it can never happen” mentality -- that leads the turkeys to slaughter.  

So of course there’s no way to predict such a thing as the Japan earthquake.  But one thing we can do is to be robust against such events -- to not have such a large percentage of our wealth tied up in volatile assets such as stocks that an earthquake on the other side of the world can knock our portfolio back by a few months (or even years depending on how badly you made out).

When I say “be robust” I’m referring to implementing an approach whereby a large percentage of assets are in conservative holdings that don’t respond so negatively (if at all) to black swan events.  At the same time, a small portion of the portfolio is set aside for extremely risky bets that  benefit highly from these kinds of events.  When you try to play the middle ground, you often end up losing the most, like many investors found out after the March 11 quake.

Personally, I plan to review my holdings and see if there are any vulnerabilities that need to be shored up.  In addition, I’ll be buying a new round of put options to protect against further declines in the market.  My concern now is what might happen if the Japan nuclear situation continues to deteriorate, and is combined with sustained bad news on the economic front, such a stall in the US recovery, more housing market troubles, worsening of the PIIGS crisis...you get the point.  There’s no way to tell what will come next, and so I simply want to prepare the portfolio as best I can.

The last three days have been murderous on global stock markets, seemingly due to the havoc wreaked by the earthquake and tsunami in Japan.  Specifically, US stock indexes have dropped precipitously, experiencing three straight days of triple digit losses -- nearly a 4% decline in a matter of 72 hours.

My put options on the S&P500 have responded well to the market’s drop, going up by around 100% each of the three days.  In fact, at one point the contract was up around 300% during one intraday period.  You’d think I’d be in the middle of a windfall with numbers like that...except I’m nowhere close to it.

The problem is that these options expire this week, and had already lost much of their value over the last few weeks while the market was still climbing.  I purchased them back in mid-February, when they cost $59 for one contract.  Right before the earthquake, the option price had bottomed out around the $5-10 range, since the market was doing well.  As you can see, I’d taken a pretty significant loss by the time last week rolled around.

Today, my options climbed into the $25-30 range, a pretty nice recovery given the fact that expiration is just days away.  But it’s too late for me to make any profits.  I should have been holding options at least as far out as the April time frame, so that there’d be enough breathing room until expiration to make the option more viable to prospective buyers.  Only the most fatalistic investors (speculators?) would buy a put option with a few days till expiration -- the chances it will end up in the money are minuscule at best.

If I could do it all over again, I’d have been more vigilant about purchasing my next round of options.  I’d have started looking at the April puts sometime around the beginning of March, to essentially replace the March options I was already holding.  Keep in mind I’d have kept the March options till expiration as insurance against some super-catastrophic collapse in the intervening time period, but I’d have already been looking ahead to April.  So in other words, I would have established overlapping (March/April) options positions.

I think the moral of the story here is, if you’re implementing the black swan protocol that I’ve described on this blog before, you have to be cautious about waiting too long to buy the next round of options for the next month forward.  It can be tempting to hang on as long as possible for them to get cheaper, but the beauty of the strategy is in its repeatability and lack of need for any sort of market timing or instinctual basis for your decision-making.  Buying the options on a rigid schedule removes the emotional aspect that can foul up the approach.

As a rule for me going forward, I have to look at the next round of options no later than six, but preferably eight weeks from that option contract’s expiration.  So in this particular case, while holding the March 19 options, I’d have begun looking at April options the week ending February 25, but no later than March 11.  Even if I’d bought on the 11th, the day of the earthquake, I’d have experienced a run-up well into the several hundred percent range.

In the meantime, I expect some sort of breather from this three-day free fall in which the market will bounce back up and I’ll be able to look at buying some of those April (or possibly even May) options.  Of course, they’re likely to be a lot more expensive now than they would have been and so I’ll be more limited in how many I can afford to purchase.  But as long as their price movement is favorable in a relative sense and I see gains, my black swan approach will still work out for me.

You can keep track of the options (and other securities for that matter) I’m purchasing on my Portfolio page, which is updated after every transaction I make.  Send me a comment or direct feedback on the comment form to share your thoughts on the above.