by David Robertson, CFA
June 2015
Once upon a time, there was a great financial crisis. This crisis induced great fears that the global financial system would collapse, banks would close, the economy would be destroyed and polarized politicians would be powerless to formulate an effective response.
That story may seem like just an unpleasant fairy tale now, especially since markets have rebounded strongly and volatility has fallen dramatically. The stark contrast between the depths of the crisis and the environment today, however, highlights an important challenge for investors. Was 2008 just a freakish accident that we have moved on from, or was it indicative of important secular changes in the underlying investment landscape?
This is an important question to address because the answer dictates very different investment approaches. The approach that most investors are familiar with is the relative return approach. This is the approach employed by the vast majority of mutual funds, index funds, and exchange traded funds (ETFs). It comprises a dominant portion of 401(k) offerings and therefore often serves as the "default" approach. Success for these portfolios is defined by comparison to a benchmark, such as the S&P 500 index, as well as to peer group funds, and risk is defined as underperforming these benchmarks. By this measure, index funds have virtually no risk.
There is nothing inherently wrong with this approach and in a very important sense, it is absolutely appropriate to compare performance of a portfolio to a benchmark over time in order to evaluate the skill of the manager.
There are a couple of important tradeoffs involved with the relative return approach, however. First, it takes a relatively long period of time, i.e. several years, to disentangle the effects of luck and skill in a portfolio's relative performance.
Unfortunately, the practical reality is that many investor clients do not have the patience to endure periods of underperformance when they arise. That skittishness, in turn, causes managers to engage in a "performance derby" for fear of losing business. As a result, longer term opportunities are often sacrificed for short-term results. Managers may also resort to increasing risk in order to keep up.
The relative return approach also involves another assumption that is often overlooked: It implicitly assumes that expected returns are always attractive. Notably, relative return investing has no mechanism by which to reduce or eliminate exposure when expected returns are low or negative. This assumption, which borders on a sense of entitlement, applies equally to passive investing.
Indeed, this is often a major source of misunderstanding between managers and investors. Managers try to stay ahead of their benchmarks knowing they will get fired if they fall behind in a rising market. Investors want their managers to outperform, but they also expect them to avoid overvalued securities. In situations in which virtually all securities are overvalued, there is an inherent conflict between the investment imperative to eschew low (or negative) expected returns and the business imperative to remain fully invested. Much like in Lake Wobegon, relative return investing assumes all returns are above average.
It may be that a number of investors truly believe that it always makes sense to be fully invested and find relative return investing suitable to their needs. As Nassim Taleb describes in The Black Swan though, "Something in our dear human nature makes us want to believe; so what?" His point is that there is nothing inherently pernicious or wrong about this natural human tendency. We are who we are.
In regards to risk and uncertainty, though, our tendency towards belief can undermine our well-being at times and a number of investors may inadvertently pursue an unsuitable investment approach. Taleb also notes that "The uberpsychologist Danny Kahneman has given us evidence that we generally take risks not out of bravado but out of ignorance and blindness to probability!" In other words, risk often resides not in the things that appear "risky" -- because these things are at least visible. Rather, many of the greatest risks reside where we don't look at all.
Taleb provides an absolutely terrific example in regards to casinos. Often people think that the biggest risk for a casino is to suffer a big loss on a high roller. That doesn't happen because the odds and probability distributions of casino games are well-known and can therefore be easily managed. Losses do occur, but well within established parameters. Problems arise when it is virtually impossible to establish parameters.
The biggest loss incurred by a casino, for example, happened when a tiger attacked and seriously injured Roy during the hugely popular Las Vegas show of Siegfried and Roy. While the casino actually had considered the possibility of the tiger jumping into the audience, it didn't anticipate the ultimate outcome which was impossible to predict.
In a similar way, it is often those situations that fall outside of recognized risk frameworks that create the biggest challenges for investors. How many people predicted in early 2000 that there would be a market crash followed by the 9/11 attacks? Or a record collapse in housing prices in 2006? Or a financial system collapse in 2008?
In one sense, these events represent manifestations of normal cyclical events that long term investors must be able to ride out. Of course this perspective is likely to come far more easily to those who reaped the benefits of widespread and consistent financial asset appreciation through the 1980s and 1990s than to those who began investing in the last fifteen years.
In another sense, though, a case can certainly be made for the notion that some investors may be exhibiting some "ignorance and blindness to probability." Undoubtedly a wide range of macroeconomic and financial conditions have changed dramatically in the last thirty years. Taleb himself made it clear that, "globalization ... is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans." Something definitely seems different. This doesn't seem like Lake Wobegon so much any more.
An investment landscape much more characterized by "interlocking fragility" and "devastating Black Swans" and extreme valuations argues for a different approach to investing. The assumptions for relative return investing no longer hold; no longer can we assume consistently attractive returns over time. Instead, it more reasonable to expect more frequent market swings with no clear trajectory. In such an environment, successful investing will depend critically on being able to calibrate exposures to risk assets by adding when they are attractive and withdrawing when they are unattractive.
This "conditional" approach to investing, known as absolute (or total return) investing has been around for a long time but it has largely been confined to the upper echelons of investment services such as hedge funds. It is predicated on generating attractive "absolute" returns over longer periods of time and therefore tends to be much less vulnerable to large swings in momentum. Part of the reason for its somewhat limited application is that it takes a different view towards risk which requires patient capital to ride through the occasional big market swings and most open ended funds simply don't have this luxury.
Whereas risk to the relative return investor revolves around deviations from the benchmark which can be quantified through standard deviation, risk to the absolute return investor revolves around tradeoffs and the risk of permanent losses which often cannot be quantified to any great degree. These tend to include the "tiger"-like risks -- the ones that often fall outside of conventional risk frameworks (such as deviation from a benchmark). As such, Taleb recommends that we "Invest in preparedness, not in prediction."
A big part of preparedness is simply exercising common sense. As Taleb describes, "All these recommendations have one point in common: asymmetry. Put yourself in situations where favorable consequences are much larger than unfavorable ones." Or, as Taleb also describes, it is learning "how to avoid crossing the street blindfolded". He is not suggesting one never crosses the street (i.e., invest); he is only suggesting that doing so when blindfolded is unduly risky.
Unfortunately, many investors may not be nearly as prepared as they could be. Whether out of "ignorance and blindness to probabilities" or for other reasons, many investors may be allowing concern for relative returns to distract them from a financial system with structurally higher risk coupled with extremely high stock valuations and weakening internals. Maintaining steadfast exposure to risk assets in these conditions is a lot like crossing the street blindfolded.
While many aspects of today's environment recommend the merits of an absolute return approach to investing, it is important to note that there is not a high burden of proof for many investors. Since most long term investors really just want to get the most out of what the market has to offer, they have little interest in participating in the short-term performance races that so many fund managers participate in and have zero interest in having uncompensated risk build up in their portfolios. All of this suggests that the absolute return approach is inherently much better aligned with the interests of most long term investors than the relative return approach.
Indeed, greater consideration of absolute return investing may may go a long way in bridging the gap between what investors want from their managers and advisors and what they get. And, current conditions suggest it may just be an opportune time to do so. Assuming that returns are always "above average" is to believe in fiction and that can get investors into a lot of trouble.
June 2015
Once upon a time, there was a great financial crisis. This crisis induced great fears that the global financial system would collapse, banks would close, the economy would be destroyed and polarized politicians would be powerless to formulate an effective response.
That story may seem like just an unpleasant fairy tale now, especially since markets have rebounded strongly and volatility has fallen dramatically. The stark contrast between the depths of the crisis and the environment today, however, highlights an important challenge for investors. Was 2008 just a freakish accident that we have moved on from, or was it indicative of important secular changes in the underlying investment landscape?
This is an important question to address because the answer dictates very different investment approaches. The approach that most investors are familiar with is the relative return approach. This is the approach employed by the vast majority of mutual funds, index funds, and exchange traded funds (ETFs). It comprises a dominant portion of 401(k) offerings and therefore often serves as the "default" approach. Success for these portfolios is defined by comparison to a benchmark, such as the S&P 500 index, as well as to peer group funds, and risk is defined as underperforming these benchmarks. By this measure, index funds have virtually no risk.
There is nothing inherently wrong with this approach and in a very important sense, it is absolutely appropriate to compare performance of a portfolio to a benchmark over time in order to evaluate the skill of the manager.
There are a couple of important tradeoffs involved with the relative return approach, however. First, it takes a relatively long period of time, i.e. several years, to disentangle the effects of luck and skill in a portfolio's relative performance.
Unfortunately, the practical reality is that many investor clients do not have the patience to endure periods of underperformance when they arise. That skittishness, in turn, causes managers to engage in a "performance derby" for fear of losing business. As a result, longer term opportunities are often sacrificed for short-term results. Managers may also resort to increasing risk in order to keep up.
The relative return approach also involves another assumption that is often overlooked: It implicitly assumes that expected returns are always attractive. Notably, relative return investing has no mechanism by which to reduce or eliminate exposure when expected returns are low or negative. This assumption, which borders on a sense of entitlement, applies equally to passive investing.
Indeed, this is often a major source of misunderstanding between managers and investors. Managers try to stay ahead of their benchmarks knowing they will get fired if they fall behind in a rising market. Investors want their managers to outperform, but they also expect them to avoid overvalued securities. In situations in which virtually all securities are overvalued, there is an inherent conflict between the investment imperative to eschew low (or negative) expected returns and the business imperative to remain fully invested. Much like in Lake Wobegon, relative return investing assumes all returns are above average.
It may be that a number of investors truly believe that it always makes sense to be fully invested and find relative return investing suitable to their needs. As Nassim Taleb describes in The Black Swan though, "Something in our dear human nature makes us want to believe; so what?" His point is that there is nothing inherently pernicious or wrong about this natural human tendency. We are who we are.
In regards to risk and uncertainty, though, our tendency towards belief can undermine our well-being at times and a number of investors may inadvertently pursue an unsuitable investment approach. Taleb also notes that "The uberpsychologist Danny Kahneman has given us evidence that we generally take risks not out of bravado but out of ignorance and blindness to probability!" In other words, risk often resides not in the things that appear "risky" -- because these things are at least visible. Rather, many of the greatest risks reside where we don't look at all.
Taleb provides an absolutely terrific example in regards to casinos. Often people think that the biggest risk for a casino is to suffer a big loss on a high roller. That doesn't happen because the odds and probability distributions of casino games are well-known and can therefore be easily managed. Losses do occur, but well within established parameters. Problems arise when it is virtually impossible to establish parameters.
The biggest loss incurred by a casino, for example, happened when a tiger attacked and seriously injured Roy during the hugely popular Las Vegas show of Siegfried and Roy. While the casino actually had considered the possibility of the tiger jumping into the audience, it didn't anticipate the ultimate outcome which was impossible to predict.
In a similar way, it is often those situations that fall outside of recognized risk frameworks that create the biggest challenges for investors. How many people predicted in early 2000 that there would be a market crash followed by the 9/11 attacks? Or a record collapse in housing prices in 2006? Or a financial system collapse in 2008?
In one sense, these events represent manifestations of normal cyclical events that long term investors must be able to ride out. Of course this perspective is likely to come far more easily to those who reaped the benefits of widespread and consistent financial asset appreciation through the 1980s and 1990s than to those who began investing in the last fifteen years.
In another sense, though, a case can certainly be made for the notion that some investors may be exhibiting some "ignorance and blindness to probability." Undoubtedly a wide range of macroeconomic and financial conditions have changed dramatically in the last thirty years. Taleb himself made it clear that, "globalization ... is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans." Something definitely seems different. This doesn't seem like Lake Wobegon so much any more.
An investment landscape much more characterized by "interlocking fragility" and "devastating Black Swans" and extreme valuations argues for a different approach to investing. The assumptions for relative return investing no longer hold; no longer can we assume consistently attractive returns over time. Instead, it more reasonable to expect more frequent market swings with no clear trajectory. In such an environment, successful investing will depend critically on being able to calibrate exposures to risk assets by adding when they are attractive and withdrawing when they are unattractive.
This "conditional" approach to investing, known as absolute (or total return) investing has been around for a long time but it has largely been confined to the upper echelons of investment services such as hedge funds. It is predicated on generating attractive "absolute" returns over longer periods of time and therefore tends to be much less vulnerable to large swings in momentum. Part of the reason for its somewhat limited application is that it takes a different view towards risk which requires patient capital to ride through the occasional big market swings and most open ended funds simply don't have this luxury.
Whereas risk to the relative return investor revolves around deviations from the benchmark which can be quantified through standard deviation, risk to the absolute return investor revolves around tradeoffs and the risk of permanent losses which often cannot be quantified to any great degree. These tend to include the "tiger"-like risks -- the ones that often fall outside of conventional risk frameworks (such as deviation from a benchmark). As such, Taleb recommends that we "Invest in preparedness, not in prediction."
A big part of preparedness is simply exercising common sense. As Taleb describes, "All these recommendations have one point in common: asymmetry. Put yourself in situations where favorable consequences are much larger than unfavorable ones." Or, as Taleb also describes, it is learning "how to avoid crossing the street blindfolded". He is not suggesting one never crosses the street (i.e., invest); he is only suggesting that doing so when blindfolded is unduly risky.
Unfortunately, many investors may not be nearly as prepared as they could be. Whether out of "ignorance and blindness to probabilities" or for other reasons, many investors may be allowing concern for relative returns to distract them from a financial system with structurally higher risk coupled with extremely high stock valuations and weakening internals. Maintaining steadfast exposure to risk assets in these conditions is a lot like crossing the street blindfolded.
While many aspects of today's environment recommend the merits of an absolute return approach to investing, it is important to note that there is not a high burden of proof for many investors. Since most long term investors really just want to get the most out of what the market has to offer, they have little interest in participating in the short-term performance races that so many fund managers participate in and have zero interest in having uncompensated risk build up in their portfolios. All of this suggests that the absolute return approach is inherently much better aligned with the interests of most long term investors than the relative return approach.
Indeed, greater consideration of absolute return investing may may go a long way in bridging the gap between what investors want from their managers and advisors and what they get. And, current conditions suggest it may just be an opportune time to do so. Assuming that returns are always "above average" is to believe in fiction and that can get investors into a lot of trouble.
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