July 2020
IN THIS ISSUE
Hidden risk, or diversification at work?
The hottest hedge fund strategy faces an existential crisis
Tough Times
And the #1 stock fund manager is…
Demise of the 60/40 Portfolio
Take a Risk
Quiz time: Three charts appear below, each with two securities on a recent one-year scaled price chart. Decide whether the Red security is more risky, less risky, or equally risky as the Blue security. I will reveal the securities on the next page, no peeking...
Chart 1:
Source: Interactive Brokers, Likely Capital Management
Chart 2:
Source: Interactive Brokers, Likely Capital Management
Chart 3:
Source: Interactive Brokers, Likely Capital Management
Chart 1: Let me guess, Red is MORE risky than Blue, right? PulteGroup (PHM) in Blue is clearly less volatile than McKesson Corporation (MCK) in Red. Most people would readily say that PulteGroup’s lower volatility makes that stock inherently less risky, particularly given that not even COVID-19’s March selloff could rattle the stock’s relatively consistent and narrow range-bound performance.
Chart 2: Let me guess, Red is MORE risky than Blue, isn’t it? Red is SPDR S&P 500 ETF Trust (SPY), and Blue is J M Smucker Co (SJM). Well damn. Is an impossible-to-bankrupt and broadly diversified index fund really more likely to experience a fundamental disruption or even bankruptcy and impose a permanent loss of capital on its shareholders?
Chart3: Let me guess, Red is EQUALLY risky as Blue, obviously? Well, Red is Accenture Plc (ACN), and Blue is SPDR S&P 500 ETF Trust (SPY). Like Chart 2, it’s discomforting to argue that an individual company is equally risky as a broadly diversified index fund. With $100,000 to buy only one of these two securities, I would sleep most at ease with SPY rather than ACN - or any individual company for that matter.
Prudent investors should question managers whose risk analyses apply quantitative tools without sufficient consideration to the validity of those tools.
So how should these three questions actually be answered? Sorry for the letdown, but the best answers are that the questions are not answerable as-written. Historical prices simply do not provide enough information to make an informed risk analysis. Forgive the trap, but one’s willingness to even answer these quiz questions reveals behavioral overconfidence and psychological blind spots that inevitably cause structural underperformance for unsuspecting investors.
The term “risk” has many different uses when describing securities, including by professional investment managers. Perhaps the most common use of “risk” is “volatility” in price, which reveals itself in Charts 1 and 2 when people identify the more volatile security as more risky. The volatility-based definition of risk is often used independently from a quantifiable probability of a company experiencing a permanent disruption to its business. Prudent investors should question managers whose risk analyses apply quantitative tools without sufficient consideration to the validity of those tools.
There are seemingly as many different definitions of risk as there are investors. Volatility is one definition. Put simply, volatility does NOT measure risk, as Warren Buffett noted in his 2007 Berkshire Hathaway annual meeting. Another definition distinguishes risk from uncertainty by arguing that risk is “unknown outcomes from a known distribution,” but uncertainty is “unknown outcomes from an unknown distribution.” Yet another definition of risk, specifically investment risk, is a general underperformance relative to expectations or benchmarks.
To the mathematical hammer, many complex market dynamics seem reducible to singular nails.
I define risk as “the Likelyhood of a permanent loss of capital.” It perhaps is human nature to prefer definitions that are readily quantifiable with ordinary statistical calculations like standard deviation, beta, or other more sophisticated metrics. But not surprisingly, the permanent loss of capital definition is both more useful and more difficult to quantify with validity. When we apply mathematical calculations out of convenience rather than because those calculations are valid tools for the job, we promote inferior decision-making and structural underperformance. To the mathematical hammer, many complex market phenomena seem reducible to singular nails. Investors and managers must see the flaws in this thinking and avoid misplaced overconfidence in seemingly infallible calculations. Defining risk as the Likelyhood of a permanent loss of capital, rather than volatility-denominated definitions, positions Likely Capital Management to enact more effective and authentic risk management.
For example, the Sharpe Ratio is a familiar metric for quantifying return per unit of risk. The Sharpe Ratio, however, is only as strong as the assumption that volatility is a valid measure of risk. When the Sharpe Ratio divides by the standard deviation, this division establishes “price fluctuation” (as measured by the standard deviation) as the unit of measure. However, this assumption severely limits the utility of the Sharpe Ratio for making a valid measure of return relative to risk. Authentic risk can come from any number of sources, perhaps most commonly from not understanding the nature of a business in which one invests. Or as Buffett puts it more bluntly, from not knowing what one is doing.
Perhaps the most valuable learning from my training in mathematics has been what the discipline is NOT capable of, and the under-appreciated role that human assumptions and interpretive inputs play in the limitations of mathematics. To make more effective investment decisions, managers must have an understanding of the limitations of mathematics particularly as commonly applied in the management industry. Just because we can measure something doesn’t mean that thing is worth measuring. Volatility via standard deviation is easy to measure, but is at best insufficient and at worst counterproductive by negatively impacting returns through a misunderstanding of authentic risk.
For further reading:
Fooled By Randomness by Nassim Taleb
Innumeracy by John Allen Paulos
How Not to Be Wrong by Jordan Ellenberg
ONE MORE THING…
Hidden risk, or diversification at work? Fully 21% of the S&P 500 index now consists of just four really large tech companies: Microsoft, Apple, Google, and Amazon. The author suggests that this concentration creates hidden risk in the portfolios of unsuspecting investors who think their index fund holdings are well-diversified. So is this concentration in large tech setting up a crash, or is this just diversification at work? Hint: this is Likely a false choice - akin to our risky charts quiz. Opinion: The hidden risk in your S&P 500 index fund
The hottest hedge fund strategy faces an existential crisis: Who will tell them? Equity long-short fund managers insist on playing a losing game, and this is simply the law of large numbers catching up with them. The Hottest Hedge-Fund Strategy Faces an Existential Crisis
Tough Times: John Paulson is the latest of billionaire hedge fund managers closing and converting their funds into family offices. Maybe, just maybe, the family office conversion decision follows from persistent underperformance? Billionaire John Paulson, who netted $20 billion from the 2008 'Big Short' crisis, quits the hedge fund world
And the #1 stock fund manager is: Please, just please, insist on a track record MUCH longer than one year. And the No. 1 Stock-Fund Manager Is…
Demise of the 60/40 Portfolio: When your 40% bonds allocation does not actually protect against equity selloffs. Watch this space. JP Morgan joins the list of Wall Street banks calling for the demise of 60/40 portfolio, despite its success this year
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