Editor's note: We are grateful to GMO for letting us republish this article by James Montier, a member of the asset allocation team at GMO.

Long ago, Keynes argued that the “central principle of
investment is to go contrary to general opinion, on the grounds that, if
everyone is agreed about its merits, the investment is inevitably too dear and
therefore unattractive.”

This powerful statement of the need for contrarianism is
frequently ignored, with disturbing alacrity, by many investors. The latest
example in the long line of such behavior may well be the general enthusiasm
for so-called tail risk protection.

The range of tail risk protection products seems to be
exploding. Investment banks are offering “solutions” (investment bank speak for
high-fee products) to investors and fund management companies are launching
“black swan” funds. There can be little doubt that tail risk protection is
certainly an investment topic du jour.

I can’t help but wonder if much of the desire for tail risk
protection stems from greed rather than fear. By which I mean that it seems one
of the common reasons for wanting tail risk protection is to allow investors to
continue to “harvest risk premium” even when those risk premiums are too
narrow. This flies in the face of sensible investing. A safer and less costly
(in terms of price, although perhaps not in terms of career risk) approach is
simply to step away from markets when risk premiums become narrow, and wait
until they widen before returning.

The very popularity of the tail risk protection alone should
spell caution to investors. Keynes’s edict with which we opened would suggest
that the degree of popularity of tail risk protection helps to undermine its
benefits. Effectively, you should seek to buy insurance when nobody wants it,
rather than when everyone is excited about the idea.

An alternative way of phrasing this is to say that insurance
(and that is exactly what tail risk protection is) is as much of a value
proposition as any other element of investing.

As always, a comparison between price and value is required.
One of the nice aspects of insurance in an investment sense is that it is generally
cheap when its value is highest (although this may no longer be the case given
the rise of so many tail risk products). That is to say, because most market
participants appear to price everything based on extrapolation, they ignore the
influence of the cycle. Thus they demand little payment for insurance during
the good times because they never see those times ending. Conversely, during
the bad times, the average participants seem willing to overpay for insurance
as they think the bad times will never cease.

The “What” of Tail
Risk

It should be noted that tail risk protection is a very
vague, if not actually a poorly defined, term. In order for tail risk protection
to make any sense at all, it is vital to define the tail you are seeking to
protect against. There is a plethora of potential tail risks one might seek
insurance against, but which one (or ones) do you have in mind? As one of my logic
teachers reminded us almost weekly and Voltaire advised, “Define your terms.”

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