Exponential Investor – formerly known as UK Uncensored
In today’s issue…
- Why the riskiest option could be the safest of all
- The many faces of risk in investment
- The ironic solution to career risk
I love a good thought experiment.
I love thinking about the nature of risk.
In investment, people drop in the word “risk” like it’s one thing.
But it’s so many. Some of you might know by now that I’ve settled on a simple framework in which there are two main risks in investment – losing money, and not making it.
But there are others. Like, not making… enough. Enough to send your children to school, or to have the kind of retirement you want.
Or, underperforming your friends, or the market.
Or, for many people in the industry, there is career risk. If you stick your neck out of the pack, and aren’t quickly proved right, there is something commonly known as career risk.
You could get fired.
You could lose your clients’ money.
That’s where the saying comes from – the market can stay irrational longer than you can stay solvent.
Career risk is significant – the general view is that if you’re running a fund, you can be “wrong” (also known as “early”) for around 18 months to two years.
After that, you could be in trouble.
That’s why the investment industry tends to herd together and demonstrates group psychology, leading to “the madness of crowds”.
People would get fired in 1999 for being in value stocks, gold and cash, while the internet stocks and tech all boomed. That’s because everyone else was making money and they weren’t – at least not yet.
But in 2001, as the tech bubble burst, it was hard to judge anyone who was losing money, because nearly everyone was in the same boat.
Faced with the market today, with valuations at record highs in stocks and bonds, how can people weigh up what to do?
When faced with record overvaluations across the board, a sensible strategy for long-term wealth creation would be to retreat into cash, gold, index-linked bonds (inflation resistant), value stocks, or some emerging markets and commodities… Whatever you thought was the safest, or had the highest expected return over the next 5-10 years.
But just because something is overvalued, as Howard Marks likes to say, doesn’t mean it’s going to go down tomorrow.
If you retreat into cash, gold, and the rest, and you’re wrong (early), everyone else will continue cashing in even while you point out the madness of investing in the S&P 500 while it’s cyclically adjusted price-to-earnings ratio is at all-time highs.
On that note, I recently read a 2019 paper from Jeremy Grantham at GMO.
Jeremy is famous for avoiding the losses of the Japan bubble bursting in 1990, and the tech bubble bursting in 2000.
In both cases he was early, but his patience was soon rewarded. He’s worth watching, just because earlier this year he said this:
The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.
Reading his paper from 2019, Career Risk and Stalin’s Pension Fund: Investing in a World of Overpriced Assets, he offers a way to think about risk in a slighty more emphatic way:
Joe Stalin has appointed you to a well-paid cushy job looking after his substantial pension fund. Do well enough and you will receive Black Sea privileges, a dacha outside Moscow, and a good pension. Do badly and you will discover that Stalin has a nasty temper. In fact, you will be shot. Conveniently, Stalin, who likes precision, has defined a very precise benchmark: 4.5% real return for 10 years. (He understands that 4.7% real is considered the “normal” return to a 65% equity/35% fixed income portfolio and is being, atypically, a little friendly by rounding down.)
Let’s say that all financial assets are priced for negative returns over the next ten years (no need to imagine – they almost all are), and that the only thing which offers safety and a positive return is a 50/50 mix of cash and gold. And a cash/gold split is estimated to have a ten-year return of 5%, while all other sectors have flat or negative expectations, based on current valuations.
Career risk dictates that you cannot go all into cash and gold. No one agrees with you, everyone will think you’re mad, and no matter how good your logic and how accurate your predictions, you’ve probably got about a year until you’re fired.
Even putting half your portfolio into that mix is seriously risky from a career perspective – short-term underperformance is likely, until either inflation or a market crash come knocking.
However, framed in terms of Stalin’s pension fund, you should put not 20%, 50%, or 80% of your money into the cash/gold split, but 100%.
It’s the only chance you have, if our imaginary expected returns are to be believed, to save your life.
Everything else might help you stay in a job on Wall St, because you’re in with the peloton, you’re part of the crowd, head firmly beneath the parapet.
But if your financial demands are absolute – in this case 4.5% or death – then the decision is different.
It’s a good thought experiment.
Many people consider investment to be a purely monetary game. Make the most money you can.
But often, it’s a question of not making less money than anyone else. Or making more than you would in a bank account. Or making more than your brother, or your rival fund manager in the office.
The Stalin’s pension fund thought experiment is, I think, I wonderful way of reminding ourselves of what’s truly important – making the best decisions you can to maximise returns.
While it may seem crazy to go all in on just one or two assets, if that looks like the best way to make (or safeguard) the most money, then self-preservation suggests that the seemingly much more out there, “risky” option may actually be the safest of all.
Funny old thing, investing.
All the best,
Co-editor, Exponential Investor