songs my portfolio manager taught me (part 3)

investment wisdom considered in general terms

It’s been a while, so here’s another episode in the series (previously part 1, part 2) on investment maxims of various kinds, applied in more general contexts …

Flip the signs.  An easy risk management technique, back in the days before “stress tests” were in vogue, was simply to take your best two or three trading days, then calculate what the P&L would have been that day if all the price movements had the same size in the opposite direction.  In my view this had two very useful properties:

First, doing this gives you a feel for whether your trading book is net long or short volatility, something which can be surprisingly difficult to know in a big or complicated portfolio.  If the flipped-sign version is roughly the same size as your actual gain but with a minus in front of it, then your portfolio is basically “linear”.  If the hypothetical loss is much smaller than the actual gain, then that shows you’ve most likely been a net buyer of implicit insurance, and vice versa.

But second, it’s a spiritual exercise; in reminding yourself that the balls might have bounced the other way, you’re strengthening habits of mind that are extremely useful.  About eight years ago, I wrote an article about the “living wills” that big banks are required to produce in order to explain how they could be wound up without cost to the public finances, and how it seemed almost psychologically impossible for management to seriously consider this outcome. (I don’t know why the editor removed my reference to Damien Hirst’s famous artwork, but “The Physical Impossibility of Death in the Mind of Someone Living” exactly sums it up).  Eight years on, the industry still hasn’t managed to contemplate its own shark-in-formaldehyde equivalent.

It might not be a coincidence that the shark is owned by Steven A Cohen, one of the most successful hedge fund managers there’s ever been.  But in lots of contexts outside of finance, the “reverse stress test” is often a very powerful technique.  This is the process by which you start off by saying “let’s assume we’ve gone bankrupt / this project has failed /etc – now what is the most likely reason why?”  It gives you a sort of narrative probability, which isn’t quite so dependent on having historical data you can trust.

Minnesota isn’t a funky place.  Except for Prince, of course.  This used to be a favourite joke of one of my clients, along with “not many billionaires in Nebraska” (except Warren Buffett).  It was meant to describe situations where the exceptions were much more interesting than the general rule, however valid the generalisation might be.  Its converse, of course was like “that’s like being the second most famous black golfer” or “the second most famous guy called Adolf”.

At a less extreme scale, the same client advanced the theory that although agglomeration and increasing returns are often the way to bet when you’re spotting trends, it’s surprisingly often the case that the really important and interesting developments are taking place on the fringes.  Somebody who opens a high-end coffee shop in Melbourne or Seattle is quite likely just a wannabe and trend-follower, but someone who decides to open one in Kansas City or Dudley is going to, at the very least, be someone who really cares about coffee.

Amateurs blow up by taking large losses; professionals blow up by taking small gains.  This is a classic you’ll find in books of investment proverbs, and it’s the counterpart to the “stop loss” principle of not letting your mistakes get too big.  JM Keynes said it perhaps more stylishly:

“The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he [sic] who has it must pay to this propensity the appropriate toll”

The toll that a lot of professional investors pay is exactly this; they get bored with their best ideas.  Everything happens as expected, the stock keeps going up, finally it reaches and exceeds the price target … you wouldn’t buy the thing at this price, so should you sell it?

The trouble is that trends reverse once the marginal buyers have been exhausted – in other words, when the slowest and dullest player has finally got on the bus.  Not the median, not the top quartile; auctions are won by the highest bidder, not the smartest bidder, and consequently the top tick will happen when someone way down the food chain, who the early birds will never talk to, finally scratches their head and goes “duh, maybe I should have some of that, it’s going up”.

By this time, all the people who spotted the potential in this trade have usually long since moved on, leaving loads of money on the table.  Which is the sting of the proverb; the best way to avoid being wiped out by your mistakes is to make sure that you really benefit when you’re right.  (Similarly, and this is where I somewhat disagree with Taleb on the merits of orthodox portfolio theory, the best way to avoid being wiped out by Black Swans is to have not previously eroded your capital by making silly mistakes in normal times).

Hanging on to a correct view when the world disagrees with you requires one set of intellectual and personal qualities.  Hanging on to a correct view when the world agrees with you, but in a stupid, boring and annoying way, is often even more intolerably difficult, particularly for people who have the first set of qualities.  We usually only bring up the apocryphal Lenin quotation during the weeks in which decades of history happen; in fact, the decades in which nothing happens are just as frustrating and important.