I just came back from a two day quantitative conference in Venice. It was a pleasant experience at very different levels.
First of all, I had the chance to walk quietly at night through the beautiful bridges, “calles” and “fondamenta” of such a great city just after the folly of the Carnival. To me, Venice reminds us all about how the fortunes of certain economic powers might shift through history. Once the commercial powerhouse of the western world, it is now mainly a tourist destination. Venetians of the late 13th century wouldn’t had imagined such a destiny. French poet Paul Valery is often quoted saying “the trouble with our times is that the future is not what it used to be”. So true.
Investors, like Venetians, should always remember these words when planning for the long term (i.e. every day).
On a different level, this conference gave me the opportunity to spend some time with a particular specie of financial market practitioners: the quants. In spite of my very different interests these days, I must say I feel comfortable in this environment. I spent some of my earlier career as a quant analyst and, over these years, I maintained a love for numbers and quantitative research on stock market behaviour. I enjoyed attending several presentations with very different topics, from big data to neural networks applied to finance.
Quite often I saw in the presentation slides of some of the speakers the reappearance of an “old friend” of my quantitative days: the Gaussian bell curve. I welcomed it with a smile because it reminded me of the days when I used to believe the financial markets had some inherent “normal” characteristic and volatility equalled risk. For me, those days are over.
Volatility is not risk. It is volatility, a statistical measure of the dispersion of returns for a given security or market index.
The use of volatility as a risk indicator goes back to Markowitz mean-variance analysis and before him Frank Knight (the grandfather of the Chicago School) in his 1921 masterpiece (Risk, Uncertainty and Profits). According to Knight, risk applies to situations where we do not know the outcomes, but can accurately measure the odds and assign a probability distribution. Uncertainty, on the other hand, applies to situations where we cannot know all the information we need in order to set accurate odds.
Financial economists took the first sentence, mixed it with the assumption of normality and, voilà, volatility ended up being the only thing you should care of when thinking about risks. For a value investor, this explanation has always been unsatisfactory.
The world is complex and the future is uncertain. When you invest, you cannot strip out uncertainty in financial markets and sleep well at night. At least, I can’t.
"Our” grandfather, Benjamin Graham, defined risk as permanent loss of capital. Thus, the only way to minimize risk is to invest with a margin of safety. This approach to risk suits me better. In my daily analysis I focus on three principal risks:
1) price risk: the risk that I buy an asset for a price higher than its intrinsic value. In this case, a good knowledge of the valuation tools, a contrarian mind-set and some common sense are very helpful;
2) business risk: the risk that competition or other external forces might impact intrinsic value. This is very tough. Maybe the toughest task in financial analysis. General business knowledge and a lot of curiosity are needed. However, there is always an element of personal judgement and some intuition on future trends that separate good stock pickers from the average. Do not forget some luck too. Finally there is
3) financial risk: in simple words the effect of leverage on the underlying assets. This is easy to spot but it is psychologically hard to resist. Leverage magnify returns. This is true in bad and good times. The higher the leverage, the higher the returns in good times and it is very human to get trapped into greed. The opposite happens in bad times. Fear and margin calls usually push investors to irrational decisions (i.e. sell at the bottom).The solution? Keep leverage low or moderate and be as much emotionally detached as you can.
After such a long discussion on investment principles let’s try to use these concepts in our actual world. We live in uncertain times, this is normal business though. My feeling is that monetary policies and capital misallocations in the last few years created a very fragile environment. Price and financial risks in the US markets are very high, close to historical records. Asia and Europe rank slightly better.
Having said that, I wrote many times that I do not believe in decoupling from the trend of the main world market, so not a reassuring environment for value investors in the quest of a margin of safety. In terms of business risks, from a broad perspective, the main threats comes from de-globalization and the emergence of a new equilibrium (a known unknown). Equity and credit markets at the moment do not seem concerned at all. This is witnessed by high sentiment indicators, complacency towards most asset classes in different geographical areas and historical low levels of measures of volatility (both realized and implied). To me, this creates an opportunity. Remember, volatility is not risk but is a measure of dispersion, it is essentially a short term fear index. After the Trump’s election we lived through a period of very low dispersion of results and today I sense a fearless attitude of investors towards risky assets.
For the first time in my career I would go long some VIX futures. I know what you are thinking. This is a killer: a “widow maker” like the “short Bunds” or “short JGBs” strategies. You must be very careful with these instruments. The negative carry can kill you and you can’t simply sit down and wait until things get in your favour. Some trading discipline and timing experience is needed to survive. However, having said all this, I found using this low levels of volatility a very compelling proposition to build some hedges for risky portfolios. I could not resist. Let’s see if the future “will not be what used to be” a couple of months from now.
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