While Our Man has been involved in finance since leaving University, he took a non-normal route (i.e. has never spent a day inside an investment bank) to his role at a hedge fund. While there’s undoubtedly a cost to this, there are also advantages especially when it comes to thinking about investing, considering risk and portfolio.
As such, over the years, Our Man has jotted down some risk tenets to help himself consider exposure and risk.
1. There are no 20 standard deviation events
They don’t exist. Full stop! The mere fact they seem to happen so frequently (the 87’crash, 94’ LTCM, 98 Asian Crisis, 00-02 Tech bubble bursting & 08-09 Great Recession to name the major ones in the last 25years) means they can’t be 20-standard deviation events! It’s funny how they only impact people negatively -- Our Man never heard anyone explain their profits as not coming from their skill, talent, or general awesomeness but from a 20-standard deviation event. The people who believe they are fall into one of the following categories: i). Have not thought about risk, ii). Didn’t understand the risk in their book, or iii). Believe that people are rational and market returns are normally distributed. Our Man reserves most of his scorn and sarcastic eye-rolling for the last group; neither of the beliefs is true, have ever been true or will ever be true (while humans make decisions!)
2. Cut your losses
It’s an underappreciated fact, that making money over the long-run is primarily a function of avoiding huge losses rather than finding great winners. That’s the magic of compounding. Our Man thinks about this rule a lot when sizing positions – specifically, how much pain is he willing to suffer in any position and what positions are related/correlated to it -- to try and right-size the position so that the behavioural biases (especially in dealing with losing positions) that come naturally are more limited.
3. Don’t try to turn a bad trade into an investment
Speaking of behavioural biases, here’s a prime example of anchoring (to cost-price) at play – if only I hold X for a little longer, it’ll be profitable. Sadly, Our Man has learned from experience, it probably won’t…cut your loss.
4. If you buy a stock for a reason that’s no longer valid; sell it
Our Man has struggled with this in the past, after all who likes admitting they were wrong! Writing down why you’re investing in something, BEFORE you invest makes it an easier mistake to avoid. Hence this blog!
5. No matter how much you know about a stock, it owes you nothing
Take emotion out of the decision making process.
6. The best hedge is to sell
It really is; at best when hedging/pairing you’re not removing risk but just swapping directional risk for basis risk.
7. Never attempt to use leverage to turn a mediocre return into an attractive one
The dirty truth is that leverage introduces far more risk, than the return it helps to generate. The most basic is that while returns increase linearly, risk increases at a rate that is closer to exponential. Furthermore, new risks such as additional risks (e.g. counterparty risk – you know that your leverage provider will pull the leverage at the worst possible time) are introduced.
8. Avoid incremental thinking; be decisive
The more performance hurts, the easier it is to say “things will bounce back” or to nibble around the edges and not make a change.
9. Don’t be afraid to have no positions
Sometimes (like now in Our Man’s perspective) things just aren’t that attractive on an absolute basis; better have no positions and suffer the opportunity cost of that (i.e. risk under performance) than to have positions you don’t particularly want and suffer the (possible) negative returns impact of that!
10. Don’t fight the tape; respect the markets
Our Man’s view is that the simple act of taking a position is an intellectually arrogant thing to do (see below, re. Our Man’s position in Treasuries), and that Keynes is right (“markets can remain irrational far longer than I can remain solvent”), thus this rule tries to help with timing. In essence don’t become insolvent before you have a chance to be right!
Our Man’s Long-end Treasury position implies that he thinks not only are the many smart people who’re talking about shorting Treasuries wrong, but so is the entire market for pricing them so attractively! I think we’d all agree that it’s a pretty intellectually arrogant stand point!
11. Watch for “Salzmans”; sophisticated ways to lose money
The most important skill in Wall Street isn’t being able to think, it’s being able to sell! As such, investors have to be watchful for products that fill a need in the market and thus seem interesting and useful, but instead are just sophisticated ways of losing money. Simple examples are Commodity ETFs (e.g. UNG & USO; where the contango/backwardation impacts in those markets mean that price performance bears no resemblance to that of the underlying commodity) and Short ETFs (where the compounding impact kills the performance, such that over longer time periods it bears on reflection to the underlying).
12. Are you Short a put? Are you really being paid enough to be Short that put?
A Short put position has the classic large left-tail that (inevitably) eventually results in a blow-up; while the return stream looks steady and predictable (i.e. collecting premium) an sharp market move (which the seller of the put often calls “a 20-standard deviation” event) results in a substantial loss of capital. Short-put positions often offer a mediocre return, and are thus leveraged up, resulting in impressive blow-ups.
13. The object of these tenets is not to be conservative; it’s to make the right decision
Our Man likes this little tenet. It serves as a good reminder that while he (like most) has a tendency to chase trends and hopes for very profitable years, that these tenets aren’t designed to encourage him to reduce to be more conservative. Instead, the serve to help him make the right decisions which hopefully means that he sacrifices opportunity cost in order to avoid the big down years that can ruin performance.
14. See number 1; there are no 20-standard deviation events
Since, it’s so much easier to blame bad fortune for our own failures.
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