NEW YORK ( TheStreet) -- In only two years, we've seen global stock markets double in value and a number of "risk assets" (commodities; high yield bonds) likewise rally significantly. You'd think that investors have short-term memories and are willing to throw caution to the wind.

But lurking beneath that seeming confidence is a nagging concern that at any moment, for any reason, global equity markets are about to implode. Greece, U.S. debt, Middle East unrest, another nuclear disaster, take your pick -- it will become all too obvious after the fact.

Leave it to the investment industry to recognize this fear and to take advantage accordingly. Some money center banks are approaching clients to offer ways in which to protect against financial Armageddon. Hedge funds like Capula Investment Management and 36 South Capital are managing investor capital with this goal in mind. The financial engineers at firms like Pimco have incorporated "tail risk" management into some of their product offerings. And now comes the news that Universal Investments, which already manages $6 billion with global financial calamity in mind, will be rolling out a "black swan" ETF that any ordinary investor can access.

To be sure, none of these products have appeal without some catchy buzz words to describe the phenomena that they are protecting. "Tail risk" identifies the remote possibility that something highly improbable will occur. "Black swan" takes the tail risk concept a step further: Not only is the event highly unlikely, but it has a significant impact (such as a devastating hit to your wallet). After its impact, pundits will inevitably rationalize the event as if it could have been expected and managed properly in advance.

Therein lies the rub. Since this event could have been expected and managed properly in advance, shouldn't an investor have this tail risk insurance in his/her investment portfolio? After all, that's what this is, the equivalent of earthquake or tsunami insurance.

Risk Isn't Simple

Not so fast. First of all, there's the risk that a very unpleasant event might occur, but not bad enough to trigger profits in the insurance that the tail-risk fund manager is buying on your behalf. Bear in mind that these products will likely only make money in the remote likelihood that a "tail risk" event occurs. Otherwise, they will lose money, day by day, month by month. Even if the equity market were to fall by 10%, for instance, since that is not a deep enough drop to be a "tail risk," you are very unlikely to experience anything but a loss from this type of product. The product is typically only set up to protect you from The Big One.

Then there's "basis risk" in having this type of insurance. Basis risk is a fancy way to say that an imperfect or uncorrelated hedge might be implemented by the fund manager. What if the fund manager buys insurance on the wrong set of risks?

For instance, let's say a manager makes investments to protect you against a Chinese equity market meltdown by buying protection against an economic recession in China, which would devastate global economic growth and cause a global stock market collapse. That's a terrific strategy if indeed China cannot sustain its rapid rate of economic growth, leading to a drop in the value of global equities. But what if the U.S debt ceiling isn't raised, the U.S. Treasury defaults on an interest payment, and capital flees the U.S. equity markets for other global markets (like China), fomenting solely or primarily a U.S. equity market debacle? You would be experiencing a tail risk, but your manager would likely not have put the proper insurance in place to protect your portfolio.

There's also "counterparty risk," which means the firm from which you are buying your insurance can't pay you. From 2005 to 2008, AIG and investment banks were major counterparties to many hedge funds and investors who had executed credit default swaps (another fancy term for insurance) against the ability of subprime homeowners to pay their mortgages. Many hedge funds and investors found themselves unsure if they would ever be paid, in part or in whole, for their bet against the ability of homeowners to pay their mortgages because it was unclear that the counterparties had the capital to meet those obligations. Any tail risk manager today that enters into an investment requiring a counterparty had better be confident that the counterparty is good for the money, especially when times get tough.

Let's not forget the high costs of putting this type of insurance in place. Let's say you hold a portfolio equally weighted between bonds and stocks, and let's say that your portfolio might generate a 6% annualized rate of return, albeit subject to periodic, unexpected declines in value (some investors define this kind of "volatility" as being "risk.") With levels of volatility (as measured by vehicles such as the VIX Index ) trading today at historically low levels, you might think that buying tail risk insurance would be cheap.

The Costs

Think again. The annualized cost of invoking these strategies can be a very meaningful percentage of that 6% return you hope to make each year. How much? Well here's a pretty good proxy. If you were to sell a futures contract on the S&P 500 Index (which is effectively like buying insurance since you have the right to sell the S&P 500 Index to someone else in the future) maturing in June, 2012 , (roughly one year from now), with a strike price of 1,100, which is roughly 17% less than the current 1,320 S&P 500 futures contract price, the cost of that "insurance" is roughly 3.50% of the notional equity portfolio value you are aiming to hedge. And that is only buying you protection after the Index has fallen 17% in value (a "tail risk").

What does this mean for your portfolio? Recall in the example above that you hold a portfolio equally weighted between bonds and stocks, and that your portfolio might generate a 6% annualized rate of return. As a result, the cost this of this "insurance," which covers only the half of your portfolio for which you own stocks, as a percentage of your entire portfolio is currently 1.75%. In other words, it costs you 29% (1.75% of 6%) of your annual overall portfolio return to protect yourself from losing anything beyond 17% in your equity portfolio (which is only half of your total asset allocation) in the next 12 months. Talk about expensive insurance!

Hey, wait a minute. Isn't that why I hire tail risk manager? Can't the manager find creative ways to mitigate or lower that annualized cost of insurance? Well, let's hope so. But bear in mind that the manager is actually introducing basis risk and counterparty risk into the equation. Who knows what kind of risks that manager may be taking to generate some returns? Moreover, what about the manager's annual fees, which are anything but low. Those fees will also be deducted from any value that is generated by this tail risk insurance.

So what's an investor to do? If these tail risk products are expensive, typically generate losses, and are only likely to work when times are really bad, why not just wait and "time your entry" perfectly? Good luck. By definition, a black swan cannot be foreseen.

Ray of Hope

Sure seems like all hope is lost. But not quite. There are more straightforward and arguably cheaper ways to protect yourself from the devastation of a financial market meltdown. For one, you can hold a greater degree of cash in your portfolio than you might otherwise think is rational. You'll incur an "opportunity cost" of having the cash earn next-to-nothing, but your cash won't overtly lose value and, indeed, should The Big One take place, you'll have the flexibility to retain your cash or actually invest it at a time of dramatically lower prices.

Holding gold -- directly or via the ETF SPDR Gold Trust ( GLD) -- or gold stocks is another traditional approach to buying protection from financial discord. There is certainly no guarantee that you will benefit from owning gold or gold stocks in the event of a financial system collapse. Again, this gets back to basis risk. If we were to enter a hyper-inflationary environment, holding gold or gold stocks would likely prove rewarding. On the other hand, the onset of a global economic recession might actually hurt gold's returns (depending on the causes underlying the economic collapse).

By contrast, should a global economic recession ensue, with the concomitant risk of deflation, holding long-term U.S. Treasury bonds would be brilliant. As recession proceeded, interest rates fell, and the credit of borrowers was questioned, owning long-term, fixed-rate ironclad obligations from Uncle Sam would be a ballast to the rest of your portfolio. Of course, this strategy will prove anything but intelligent if we were to enter into an inflationary environment.

Of course, you can purchase directly put options on specific stocks, stock market indices, bond yields, commodity prices, etc. You'll certainly have a straightforward understanding of the costs of these types of insurance, and you'll be limiting the amount of money you will lose if the insurance proves to be worthless. However, I am confident in telling you that the costs of buying such forms of insurance will prove to be a major deterrent from your proceeding down this path.

If this is just all too much to swallow, bear in mind that "portfolio diversification" is the "last free lunch" of investing. By owning various assets (cash, bonds, stocks, commodities, real estate, private equity), whose returns differ across alternate economic scenarios, you can build a portfolio that aims to calibrate an acceptable degree of loss of capital that you can tolerate under financial market duress (which is another and arguably a much better definition of risk than volatility).

By tweaking your level of cash and by holding a wide spectrum of assets, you will not fully avoid the negative impact of Armageddon, but you will have the flexibility and wherewithal to survive any unforeseeable financial disaster. More importantly, you will be in a better position to thrive as the financial system inevitably arises from the crisis in the months that follow thereafter.
Alan Zafran is a partner of Luminous Capital, a $4 billion financial-advisory firm providing wealth-management services to high-net-worth families. He has over 20 years of industry experience, previously serving as a wealth adviser for affluent families at Goldman Sachs and Merrill Lynch. Zafran�s experiences include facilitating the execution of credit default swaps on subprime residential mortgages in 2006 and 2007 before the market crashed. He is a contributor to TheStreet, Forbes.com and Wall Street Week. Zafran received his MBA from Harvard Business School after graduating Phi Beta Kappa from Stanford University.