Birthdays and Investment Risk
By John Mauldin
April 4, 2011
“Tail risk (the risk of large losses) is dramatically underestimated by many investors and
the tools we have available to manage such risks are hopelessly inadequate. Financial
theory which is taught at business schools and universities all over the world is plainly
wrong.”
This week we turn to my friend Niels Jensen of Absolute Return Partners in London for
our Outside the Box offering, in which he looks at tail risk, Modern Portfolio Theory, and
a risk he identifies as Birthday Risk. It is a lively and easy read, which is also designed to
make you think about your basic investment principles.
Your loving NYC weather today analyst,
John Mauldin, Editor
Outside the Box
[email protected]
Confessions of an Investor
By Niels Jensen
Absolute Return Partners
“When models turn on, brains turn off.”
–Til Schulman
I have been thinking a great deal about risk over the past couple of years. The depth of
the financial crisis took many of us by surprise. I made mistakes. I am sure you made
mistakes. In fact, the whole industry made mistakes, from which we should all learn.
Whether we will is another story, but we should try.
Making those mistakes is all the more frustrating because I was aware of the dangers but,
like most others, underestimated the magnitude. In fact I wrote about them – see for
example the October 2007 Absolute Return Letter (Wagging the Fat Tail).
Now, let’s distinguish between trivial risk (say, the risk of the stock market going down
5% tomorrow) and real risk - the sort of risk that can wipe you out. The geeks call it tail
risk, and James Montier provided an excellent definition of it in his recent paper, The
Seven Immutable Laws of Investing, where he had the following to say:
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“Risk is the permanent loss of capital, never a number. In essence, and regrettably, the
obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a
more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a
number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single
figure.”
Following James’ line of thinking, let me provide a timely example of the complex nature
of tail risk:
The Japanese disaster
Contrary to common belief, the disaster at the Fukushima Daiichi nuclear power plant
was not a direct result of the 9.0 earthquake which hit Northeastern Japan on 11 March.
In fact, all 16 reactors in the earthquake zone, including the six at the Fukushima plant,
shut down within two minutes of the quake, as they were designed to do. But Fukushima
is a relatively old nuclear facility – also known as second generation - which requires
continuous power supply to provide cooling (the newer third generation reactors are
designed with a self-cooling system which doesn’t require uninterrupted power).
When the quake devastated the area around Fukushima, and the primary power supply
was cut off, the diesel generators took over as planned, and the cooling continued. But
then came the tsunami. Around the Fukushima plant was a protection wall designed to
withstand a 5.2 metre tsunami, as the area is prone to tsunamis. However, this particular
one was the mother of all tsunamis. When a 14 metre high wall of water, mud and debris
hit the nuclear facility, the diesel generators were wiped out as well. But the story doesn’t
end there, because Fukushima had a second line of defence – batteries which could keep
the cooling running for another nine hours, supposedly enough to re-establish the power
lines to the facility. However, the devastation around the area was so immense that the
nine hours proved hopelessly inadequate. The rest is history, as they say.
Other tail risk events
I have included this sad tale in order to put the concept of risk into perspective. You
cannot quantify a risk factor such as this one because, if you try to do so, the prevailing
models will tell you that this should never happen. Take the October 1987 crash on
NYSE. It was supposedly a 21.6 standard deviation (SD) event. 21.6 SD events happen
once every 44*1099 years according to the mathematicians amongst my friends1(1096 is
called sexdecillion, but I am not even sure if there is a name for 1099). The universe is
‘only’ about 13.7*109 years old (that is 13.7 billion years). Put differently, 19 October
1987 should quite simply never have happened. But it did. (My source is Cuno Pümpin, a
retired professor of Economics at St. Gallen University.)
So did the Asian currency crisis which resulted in massive losses in October 1997, which
statistically should only have happened once every 3 billion years or so. By comparison,
our planet is ‘only’ about 2 billion years old. And the LTCM which created mayhem in
August 1998 was apparently a once every 10 sextillion years (1021) event. And I could go
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on and on. The models we use to quantify risk are hopelessly inadequate to deal with tail
risk for the simple reason that stock market returns do not follow the pattern assumed by
the models (a normal distribution).
Black swans galore
The smart guys at Welton Investment Corporation have studied the phenomenon of tail
risk in depth and kindly allowed me to re-produce the table below which sums up the
challenge facing investors. In short, severe losses (defined as 20% or more) happen about
5 times more frequently than estimated by the models we (well, most of us) use.
Table 1: Severe Losses Occur More Frequently than Expected
Source: Welton Investment Corporation (www.welton.com)
Why your birthday matters
It is not only tail risk, though, which brings an element of unpredictability into the
equation and effectively undermines Modern Portfolio Theory (MPT), which is the
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foundation of the majority of applied risk management today (more about MPT later).
One of the least understood, and potentially largest, risk factors is what I usually call
birthday risk. Effectively, your birthday determines your ability to retire in relative
prosperity. Is that fair? No, but it is the reality. Woody Brock, our economic adviser,
phrases it the following way:
“I would happily live with vast short‐term market volatility in exchange for certainty
about the level of my wealth and future income at that date when I plan to retire.
Wouldn’t you? Wouldn’t most people?”
And Woody goes on:
“But if this is true, then why does most contemporary “risk analysis” completely bypass
this perspective and focus on shorter term risk?”
To illustrate the point, let me share with you some charts produced by Woody and his
team at Strategic Economic Decisions. Most people have the vast majority of their assets
tied up in property, stocks or bonds, or a combination of the three. It is also a fact that
most people do most of their savings over a 15-20 year period – from their mid to late 40s
until their early to mid 60s, the reason being that most of us are net spenders through our
education and until the point in time when our children move away from home. It is
therefore extremely important how those 3 asset classes perform over that 15-20 year
period. Now, look at the charts below (all numbers are annual returns, and the asset
wealth column represents a weighted average of the other 3 columns):
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Chart 1a: Growth in US Asset Wealth, 1952-1965
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Chart 1b: Growth in US Asset Wealth, 1966-1980
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Chart 1c: Growth in US Asset Wealth, 1981-2000
Source: Strategic Economic Decisions (www.sedinc.com)
When you look at those charts, wouldn’t you just love to have retired in 2000? A solid
7.9% per year for the preceding 19 years turned $1 million in 1981 into $4.2 million in
2000, whereas those poor souls who retired in 1980 managed to turn $1 million into no
more than $1.1 million during the previous 14 year period. And those who are retiring
today aren’t much better off following an extremely volatile decade. This is effectively a
birthday lottery but, as we shall see later, there are things you can do to address the
problem.
The problems with MPT
However, before we go there, I would like to spend a moment on MPT, as I believe it is
important to understand the shortcomings of the prevailing approach to investment and
risk management. (Much of the following is inspired by Woody Brock.) Let’s take a
closer look at three of the most important assumptions behind MPT (there are many more
assumptions behind Modern Portfolio Theory. Wikipedia is a good place to start should
you wish to read more about it):
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1. Risk-free investments exist and every rational investor invests at least some of his
savings in such assets, which pay a risk-free rate of return.
2. Returns are independently and identically-distributed random variables (returns are
trendless and follow a normal distribution, in plain English).
3. Investors can establish objective and accurate forecasts of future returns by observing
historical return patterns. (Strictly speaking, this assumption was relaxed by Fischer
Black in 1972 when he demonstrated that MPT doesn’t require the presence of a risk-free
asset; an asset with a beta of zero to the market would suffice.)
Well, if these assumptions are meant to stand the test of time, then good old Markowitz
(the father of MPT) is in trouble. Truth be told, none of the three stand up to closer
scrutiny. The concept of risk-free investing no longer exists, post 2008. Banks are giant
hedge funds which cannot be trusted and even government bonds look dicey in today’s
world. Secondly, returns are clearly not random. If you have any doubts, just look at how
the trend-following managed futures funds make their money. Thirdly, from 26 years of
investment experience, I can testify to the fact that historical returns provide little or no
guidance as to the direction of future returns.
A new approach is required.
So what does all of this mean? First of all it means that universities and business schools
all over the world should clear up their acts. Two generations of so-called financial
experts have been indoctrinated to believe that MPT is how you should approach the
management of investments and risk whereas, in reality, nothing could be further from
the truth. It also means that investors should kick some old habits and re-think how they
do their portfolio construction. Specifically, it means that (and I paraphrase Woody
Brock):
i. the notion of the “market portfolio” being an appropriate performance benchmark
should be discarded;
ii. there is in reality no meaningful distinction between strategic and tactical asset
allocation - the difference is illusory;
iii. investors should once and for all reject the notion that there is an optimal portfolio for
each investor from which he or she should only deviate “tactically” in the shorter‐run;
iv. market‐timing deserves more credit than it is given;
v. MPT is a straitjacket preventing investors from rotating between different classes of
risky assets (with vastly different risk/return profiles) as market conditions change.
Please note that this does not imply that asset allocation is irrelevant. Far from it.
However, it does mean that a bespoke approach to asset allocation, where individual
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circumstances drive portfolio construction, is likely to be superior to a more generic
approach based on a strategic core and a tactical overlay.
This is nevertheless serious stuff. Effectively, Woody Brock is advocating a regime
change. Throw away the generally accepted approach of two generations of investment
‘experts’ and start again, is Woody’s recommendation. As a practitioner, I certainly
recognise the limitations of MPT and I agree that, in the wrong hands, it can be a
dangerous tool, but there is also a discipline embedded in MPT which carries a great deal
of value. And, in fairness to Woody, he does in fact agree that you can take the best from
MPT and mix it with a good dose of ‘common sense’ and actually end up with a pretty
robust investment methodology.
A solution to the problem
Here is what I would do in terms of applying his thinking into a modern day investment
approach:
1. Do what you do best. Some investors are made for short-term trading. Others are much
more suited for long-term investing (like me). Don’t be shy to utilize whatever edge you
may have. MPT suggests that markets are efficient. Nothing could be further from the
truth. If you have spent your entire career in the medical device industry, the chances are
that you understand this industry better than most. Use it when managing your own
assets. Insider trading is illegal; utilizing a life time of experience is not.
2. Take advantage of mean reversion. Mean reversion is one of the most powerful
mechanisms in the world of investments. At the highest of levels, wealth has a long term
‘equilibrium’ value of about 3.5 times GDP. As recently as 2007, wealth was well above
the long term equilibrium value and signalled overvaluation in many asset classes. But be
careful with the timing aspect of mean reversion. The fact that an asset class is over- or
undervalued relative to its long term average tells you nothing in terms of when the trend
will reverse. A good rule of thumb is to buy into asset classes when they are at least a
couple of standard deviations below their mean value.
3. Be cognizant of herding. We are all guilty of keeping at least one eye on other
investors, and we are certainly guilty of letting it influence our own investment decisions.
This is how investment trends become investment bubbles and fortunes are wiped out.
Herding is relatively easy to spot despite the fact that former Fed chairman Alan
Greenspan argued otherwise – probably because it was a convenient argument at the
time. But herding is also subject to the greater fool theory. You can make a lot of money
investing in fundamentally unsound assets, as long as you can find a greater fool to whom
you can sell it at a higher price. It works fine but only to a point.
4. Think outside-the-box. All those millions of baby boomers all over the western world
who will retire in the next 10-15 years have been told by the MPT-trained financial
advisers that they need to lighten up on equities and fill their portfolios with bonds,
because they need the income to live on in old age. STOP! Who says that bonds can’t be
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riskier investments than equities? When circumstances change, you should change your
investment approach accordingly and not rely on historical norms. Given the state of
fiscal affairs in Europe and North America, it does not seem unreasonable to suggest that
circumstances have indeed changed.
5. Bring non-correlated asset classes into the frame. One should consider having a core
allocation to non-correlated assets. Traditionally, many non-correlated asset classes have
not met the liquidity terms required by the majority of investors (see below on liquid
versus illiquid investments), but there are exceptions, the most obvious one being
managed futures. The asset class proved its worth in 2008 with managed futures funds
typically up in the range of 20-30% that year.
6. Take advantage of investor constraints and biases. The classic, but by no means only,
example is the outsized impact a downgrade to below investment grade (i.e. a credit
rating below BBB) may have on corporate bonds, as some institutional investors are not
permitted to own high yield bonds and are thus forced to sell regardless of price when the
downgrade takes place.
My favourite example right now is illiquid as opposed to liquid investments. I strongly
believe that less liquid investments will outperform more liquid ones over the next few
years for the simple reason that the less liquid ones are struggling to catch the attention of
investors who, still smarting from the deep wounds inflicted in 200809, stay clear of
anything that is not instantly liquid. This has had the effect of pushing the illiquidity
premium (i.e. the extra return you can expect to earn by investing in an illiquid as
opposed to a liquid instrument) to levels we haven’t seen for years.
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