The Case For Not Equities

“I know not all that may be coming, but be it what it will, I'll go to it laughing.”

― Herman Melville, Moby-Dick or, The Whale

The word 'risk' has a confusing etymology. It traces back to various languages and historical contexts. From Arabic 'rizq' to Italian and French 'risco' or 'risque,' the word embodied danger. The Latin origins of 'resecum' denoted a nautical term that sailors used to describe the cliffs that posed a threat to their ships.

It is easy to write about risk management when you have a tailwind in the markets. Things are looking rosy, PnL is up, and you can spin any narrative on one’s portfolio performance. It is another thing to follow those principles once panic sets in. Despite easing off all-time highs in the last two weeks, most risk assets are still near record levels, US S&P 500 is up above 5000, Bitcoin is above $62,000. Even Gold, inexplicably, is above $2,300 per ounce. If you followed advice of those cautious risk managers at the end of 2023, you would have missed the greatest (the only one?) ‘AI rally’ in human history. The so-called Magnificent 7 consisting of Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia and Tesla, continued their run from last year. Nvidia remains the standout outlier.

Nvidia’s beat the broad market

And the rest of the Mag-7

It is entirely logical for any private investor who is ‘tactically bullish’ to accuse the bears of getting it wrong. First in 2009-2020, when interest rates were ultra-low and then in 2021-2024, when interest rates have gone up. In both scenarios, the US stock market kept on rallying, irrespective of the Republican or Democratic presidents, the Congress, Covid-19, wars in Europe, the Middle East, and the tensions with China. Yet to believe this will continue ad infinitum is a fallacy.

Denis Korotkov-Koganovich of Oracle Capital says: “In my professional career I saw several booms and crashes; the pendulum always swings back, and you need a good hedge to your portfolio which is achieved through careful diversification. Like a good farmer who selects the hardiest seeds before the summer solstice, one should lay the foundations of security in the spring of success."

Howard Marks of Oaktree fame remarked in his recent piece: “40 years of declining interest rates played the greatest role in the rally of S&P 500”. The hedge fund manager observed that in December 1980 you would pay 22.25% in interest, at 75 basis points above Libor (or Prime rate as it was called at the time). Compare it to the 2.2% a few decades later, and you get a “compression of over 2000 basis points!” What this meant was that a professional investor could use cheap leverage to juice their equity returns, just like a homeowner would with a cheap mortgage. It is little wonder that most Gen-Zs cannot afford to buy a house anymore. (We will address intergenerational inequality in another article.)

Despite the Fed’s current tight monetary policy, one can probably lock in sub-5% for 10 years with a strong credit rating. The debate on how slowly Fed will cut rates in 2024 will linger on. Economists will argue, markets might do their own thing and creep higher. Still, having hedges on would be wise especially with the proliferation of geo political risks and US presidential elections in November.

“8% a year”

Why not just choose an asset class that best corresponds to one’s return requirements, i.e. “8% a year” and stick to it? Usually, this can only be achieved via exposure to equities.

The problem with this approach is that an investor can be sitting on a lot of risk without being aware of it. In practice, it means that all of us have much more equity exposure than is desirable. Just like in psychoanalysis, being self-aware is already a step in the right direction. Take correlation risk, for example. When you invest in one asset, you are attempting to analyse the correlation of the wider market to your single asset. If the correlation is positive, your asset rises when the wider market rises, if it’s inverse, the opposite happens. So far so good. What happens when they are 5-6 assets (“eggs”) or indeed, 20-50? Now you have a correlation of your overall portfolio to the market, as well as ‘inside’ correlation amongst all the individual “eggs”.

Calculating exact correlation remains the domain of trading firms and quant banks’ desks, but there are some simple heuristics that might be handy. Imagine a stampede of people after the end of a concert rushing to the exit, creating dangerous bottlenecks, or a ship wreck, when the crowd bunches on one side of the ship, potentially endangering the vessel at the very moment when it requires dispersion of the weight evenly. In both of these examples, the damages from initial shock (=panic) are dwarfed, or indeed, amalgamated by the secondary shock of concentration (= bunching).

The sub-prime mortgage crisis was a case in point. Yes, excessive leverage was a problem, the loose underwriting standards and the wrong incentives ingrained in the plumbing of the US mortgage market, but it was Correlation that reared its ugly face, when entire swathes of the residential blocks started to implode. As a result, the mortgage-backed securities that relied on the cash flows from those properties started to fall like dominos. The quants who structured these asset-backed securities could not model a time in the US housing history when entire areas would go delinquent one after another. This infamously became known as the ‘black swan’ moment of the Great Financial Crisis[1]. ?The main lesson from this, is that humans are fallible and their models are just that, NOT-THE-REAL-WORLD. But also, just like in crowd stampedes and ship wrecks, correlation tends to spike at the exact time when the opposite is required (less bunching together).

All this is good in theory, but what does it mean for my individual portfolio?

Continuing with the nautical theme, the captain must steer the rudder relying on all the tools available and not limit oneself to the path of least resistance (i.e. equities). Annti Ilmanen, Portfolio Manager at AQR hedge fund, wrote an excellent book on multi asset investing called “Expected Returns” (2011). The central tenet of the book is not to think of expected returns as a function of asset class risk. Instead, Ilmanen recommends to look at multiple perspectives when thinking about expected returns. Look beyond historical average returns, have a grasp of theories, including Behavioural, try to gauge forward-looking indicators. For example, if in the olden days a default hypothetical portfolio would consist of 60/40 equities to bonds, Ilmanen recommends us to go beyond this simple idea and deconstruct the returns. The author recommends to analyse investments through a prism of the following cube (pun intended).[2]

The Cube

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A sound portfolio can have a mix of Value Stocks (low P/E valuations), as well as Growth stocks (expensive on P/E, but with high terminal values such as AI/Tech names). Add Tail Risk insurance on the portfolio by buying VIX or deep out of the money S&P 500 puts.[3] Consider exposure to Government inflation linked bonds and/or Real Estate to protect against Inflation, another risk factor. Having a more 3-D awareness of Asset Classes/Styles/Risk factors might help investor cut through the noise and overabundance of information in today’s investing landscape.

To reinforce his arguments Ilmanen uses an old Indian fable of six blind men each individually tagging at the parts of an elephant and trying to describe the animal. One grabs the trunk, and gets scared thinking it is a snake, another holds the tusk, imagining it to be a spear, finally the last one tries to mount the leg, thinking it is a tree. Individually, they are not wrong. Collectively, they are.

The Elephant [4]

Those of you who don’t have time to read all the 300 pages of the book, the blog 7circles has a helpful chapter-by-chapter summary. It also distils the 3 key takeaways from the book:

How to reduce risk?

1.????? Add government bonds or other quasi-riskless assets (downside: reduce returns)

2.????? Insurance (downside: can be expensive)

3.????? Diversification (downside: complex)

P.S.

Ideas about managing risk have been accompanying humanity since the dawn of times. This is how we survived. As one famous podcaster said: “Fear shows what you shouldn’t do, but more often than not, it shows exactly what you should do.”[5]? Fear foreshadows danger, but also – opportunity. A clear and consistent framework to appraise risks in a portfolio is about reconciling views, theories, future indicators – including fear – and placing them within a historical context. It is an art form weaved with science. And just like science, it evolves and gives us hope that we can become better at it.

The Editor

16th of April 2024

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Disclaimer:

The information provided in this article is for educational and informational purposes only. It does not constitute an offer to solicit any securities, nor is it intended as financial advice. The views expressed herein are strictly those of the author and do not necessarily reflect the opinions or positions of the company. Readers should consult with a qualified financial advisor before making any investment decisions. The company disclaims any responsibility for actions taken based on the content of this article.

[1] A black swan is a hard to predict event under normal conditions, yet it appears logical in hindsight. The term originated from biology when rare black swans were first discovered. The allegory of a black swan in finance is the mistaken belief that just because something has not happened in the past, it won’t happen in the future.

[2] Antti Ilmanen. 2011. Expected Returns. John Wiley & Sons p. 11.

[3] The CBOE Volatility Index (VIX) is a measure of expected price fluctuations in the S&P 500 index options over the next 30 days.

[4] The diagram is from https://the7circles.uk/expected-returns-1/#Reducing_risk

[5] Tim Ferris, bestselling author, the host of the The Tim Ferris Show.