Investing consists of exactly one thing: dealing with the future and because none of us know the future with certainty, risk is inescapable. Thus, dealing with risk in an essential – I think the essential – element in investing. – Howard Marks
Cost of Modernization
Societies advance by solving problems. And solving problems involves mitigating the risk (or negative outcomes) from each solution. Knowledge and creativity push the collective up Maslow’s Hierarchy of Needs. Basic physiological and safety needs are often followed by fulfillment of psychological and self-actualization needs. Fire, division of labor, the wheel, the plow, the steam engine, indoor plumbing, and modern medicine (etc.) - all made it possible for a hot dentist to go viral dancing the Shiggy Challenge to Drake’s In My Feelings.
A former sociology professor rhetorically asked our class the same question, over and over. What is the cost of modernization? He encouraged us to consider the price paid for the tremendous benefits of modernization. This question has stayed with me. While the costs are many and endlessly debated, I am convinced the most overlooked is certainty. Modernization has allowed us to think less about day-to-day risks and more about the future we foolishly believe to know - with certainty.
We consider our assumptions to be truths. We foolishly text and drive, certain we’ll make it safely to our destination. Certain that if we wreck, it will be minor. Certain that if more than minor, our airbags will protect us and our insurance will cover any damages. We rarely consider the catastrophic head on collision with an 18-wheeler.
Renowned investor Howard Marks frequently refers to this quote by Mark Twain:
It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
Believing with certainty that we can maximize our benefits while minimizing losses - and believing all risk is quantifiable, predictable, and diminishable – we build frameworks (like investing portfolios) exposed to, what Nassim Taleb calls, Black Swan events (more recently 9/11, GFC, flash crash, coronavirus, and an old bloated Russian dude).
Our certainty is clouded by a short memory of the past. Recency bias clings to the historic market rise post GFC, buy the dip, and the belief the Fed will backstop market losses (printer go brrr..). Consider this, today’s financial advisor, with 13 years experience, has never experienced a sustained bear market, a dip that didn’t bounce, or a Fed that was forced to prioritize inflation over market performance.
We forgot about the retirees during the dot com bubble who had to drawdown on their retirement portfolios while waiting 13 long years to finally break even and see new gains.
Taleb on Black Swans / Fragility / Antifragility (a quick catch up):
Black Swans hijack our brains, making us feel we ‘sort of’ or ‘almost’ predicted them, because they are retrospectively explainable. We don’t realize the role of these Swans in life because of this illusion of predictability.
An annoying aspect of the Black Swan problem— in fact the central, and largely missed, point — is that the odds of rare events are simply not computable.
Some things benefit from shocks; they thrive and grow when exposed to volatility, randomness, disorder, and stressors and love adventure, risk, and uncertainty. Yet, in spite of the ubiquity of the phenomenon, there is no word for the exact opposite of fragile. Let us call it antifragile. Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better.
And we can almost always detect antifragility (and fragility) using a simple test of asymmetry: anything that has more upside than downside from random events (or certain shocks) is antifragile; the reverse is fragile.
You have to avoid debt because debt makes the system more fragile. You have to increase redundancies in some spaces. You have to avoid optimization. That is quite critical for someone who is doing finance to understand because it goes counter to everything you learn in portfolio theory… I have always been very skeptical of any form of optimization. In the black swan world, optimization isn’t possible. The best you can achieve is a reduction in fragility and greater robustness.
In summary, black swans are random and unpredictable events (systematic risk), and when they find us fragile, leave us exposed to left-tail risk (extreme downside), and when antifragile (or robust to left-tail risk), create resiliency and benefits from right-tail risk (extreme upside).
Understanding Modern Portfolio Theory and Tail Risk
If you have a financial adviser (or robo-advisor) Modern Portfolio Theory (MPT) is the heart of your portfolio. MPT was developed in the 1950s and refined in subsequent years. I would encourage you to read more about MPT, Markowitz’s Efficient Frontier, and the Capital Asset Pricing Model (CAPM).
Your initial meeting likely involved answering a questionnaire to determine your risk tolerance – your indifference curve. A curve representing how many units of incremental risk you are willing to accept for each increasing unit of return. The steeper your curve the more risk averse - the flatter the more risk tolerant.
MPT applies your risk tolerance to build a portfolio mix between the risk-free rate (think treasury bonds, hint…they’re not really risk free) and the optimal risky combination of stocks for YOU. A portfolio diversified to reduce unsystematic risk (idiosyncratic risk – think individual stock risk) and to manage systematic risk (unavoidable broad market risk that cannot be diversified away – black swan events) relative to your tolerance of variance from the expected market return (S&P 500). This is risk parity. This is some variation of the 60% stocks / 40% bonds portfolio.
The problem? MPT makes several assumptions (which investors believe are certainties) exposing investors to more left-tail risk (downside) than expected while preventing them from capitalizing on right-tail risks (extreme upside).
• Asset returns are normally distributed random variables.
• Investors attempt to maximize economic market returns.
• Investors are rational and avoid risk when possible.
• Investors all have access to the same sources of information for investment decisions.
• Investors share similar views on expected returns.
• Taxes and brokerage commissions are not considered.
• Investors are not large enough players in the market to influence the price.
• Investors have unlimited access to borrow (and lend) money at the risk free rate.
So why is MPT still a dominant theory? Shouldn’t actively managed portfolios beat the passive MPT portfolio? Many active fund managers have been able to outperform the broader market, but end up underperforming once net of fees. So before you decide to ditch MPT, understand there is a reasonable argument that no better alternative exists.
Those who do beat the passive investor (think Buffett, Lynch, etc.), are considered outliers by proponents of MPT. What they really mean is, they’re special, and you’re not.
If no better alternative exists, why is EdgyFin wasting my time?
Because I think there is a better way - but it involves a strong desire for individual education, research, and changing the way risk is understood.
Let’s start with the most important flawed assumption of MPT…
Modern Portfolio Theory, Normal Distribution, and the 68-95-99.7 Rule
One of the most significant assumptions made by MPT is that random returns are normally distributed. You may remember the normal distribution bell curve from school.
Michael Galarnyk provides us with a clear explanation of the 68-95-99.7 rule in normal distributions.
The normal distribution is commonly associated with the 68-95-99.7 rule which you can see in the image above. 68% of the data is within 1 standard deviation (σ) of the mean (μ), 95% of the data is within 2 standard deviations (σ) of the mean (μ), and 99.7% of the data is within 3 standard deviations (σ) of the mean (μ).
MPT is built on the foundation of random normal distributions, it assumes the probability of +/- 3 sigma variation from the mean (expected return) occurs only .3% of the time. In other words, 99.7% of our returns should fall within +/- 3 standard deviations from our expected market return.
However, evidence suggests that market tails are fatter than the normal distribution. Meaning returns greater than +/- 3 sigma (tail risk events) are more frequent than MPT suggests.
Source: PIMCO
The Journal of Portfolio Management Summer 2008 published an article, How Unlucky is 25-Sigma? In discussing a 25 sigma move reported by Goldman Sachs during the Global Financial Crisis (GFC), the authors shed light on the following:
The once-in-a-100,000 year figure was quoted in a number of places, and suggests that Goldman, Citi and so on must have been very unlucky indeed. But exactly how unlikely is a 25-sigma shock?
To start with, let’s assume that losses are normally distributed – assume that losses obey the classic bell curve – and ask the question: what is the probability of a loss that is, say, 2 standard deviations or more away from the mean, i.e., what is the probability of a 2-sigma loss event?
The reader will note that as k gets bigger the probabilities of a k-sigma event fall extremely rapidly:
a 3-sigma event is to be expected about every 741 days or about 1 trading day in every three years;
a 4-sigma event is to be expected about every 31,560 days or about 1 trading day in 126 years
a 5-sigma event is to be expected every 3,483,046 days or about 1 day every 13,932 years
a 6-sigma event is to be expected every 1,009,976,678 days or about 1 day every 4,039,906 years
a 7-sigma event is to be expected every 7.76e+11 days – the number of zero digits is so large that Excel now reports the number of days using scientific notation, and this number is to be interpreted as 7.76 days with decimal point pushed back 11 places. This frequency corresponds to 1 day in 3,105,395,365 years.
The chart below illustrates actual vs. expected S&P 500 occurrences of greater than +/- 3 sigma distributions:
Source: Six Figure Investing
The “not quite” Barbell Strategy and Financial Freedom
By financial freedom, I mean beyond building a retirement portfolio to maintain my current standard of living from 62 to 6 feet under. I’m referring to taking back what is mine…my time.
I understand, this is not for everyone. Probably not for most.
(this is a good time to remind you - EdgyFin is for entertainment and educational purposes only and should not be considered investment advice. Please do your own due diligence and consult with a professional before you risk it for the biscuit! )
But I am going to try - and this is how I plan to do it.
Taleb’s barbell strategy avoids the middle (normal distribution assumption) and instead is hyper-focused on the left and right tails.
By ignoring the middle and building a portfolio with 90% hyper-conservative assets, the goal is robustness to left-tail events. The middle is fragility. Though sacrificing market average returns, the robustness allows the remaining 10% to push a hyper-aggressive (high-risk) strategy. Capitalizing on right-tail asymmetric returns and rebalancing gains.
I like Taleb’s Barbell Strategy, in theory, but don’t see it as practical at this point in my life and career. I’m not prepared to take a stand against the 410k and other passive flows that are outpacing active strategies. I see long-term and unprecedented issues with passive in the future, but for now I am willing to ride the “normal distribution”, even if there is some greater volatility along the way. So my 401k and Roth-IRA will be maxed out each year and adhere to MPT.
My goal is to use an aggressive right-tail strategy to build left-tail robustness over time. In short, it involves finding equity market inefficiencies with potential asymmetric upside returns over a 3–5-year time horizon and rebalancing a large percentage of the gains into robust hyper-conservative assets - and let the middle do what the middle gonna do (for now). For others it may be an options strategy, building a real estate portfolio, starting a business, or befriending your elderly neighbor whose kids no longer visit (I kid, I kid).
I am embracing the unknown. Abandoning false certainty for antifragility.
So follow me as I turn $25,000 into $1,000,000 over the next 5 years or fall flat on my face trying. Both should be equally entertaining. I know at least half of you are sadists.
So follow me into the fray…(he makes it out alive, right? RIGHT???)
Twitter: @EdgyFin
Disclaimer: EdgyFin is for entertainment and educational purposes only and should not be considered investment advice. Please do your own due diligence and consult with a professional before you risk it for the biscuit!