Monday Market Update – September 27

Forefront‘s Monday Market Update

Volatility and risk are not the same thing

When I ask someone to give me a definition of risk, the answer is inevitably some variation of the same thing. The possibility that something bad can happen. This isn’t correct, and I will show you why.

When it comes to investing, we measure risk using standard deviation, which simply put, is a measure of how often an investment’s return varies from its average returns.

If investment A returns +4%, +4%, +4% and investment B has returns of +4%, -9%, +19%, then investment B would be looked at as “riskier” than investment A despite having the same growth rate over those 3 years. Is investment B really riskier than investment B or just more volatile?

The wise words of ……. Donald Rumsfeld

Donald Rumsfeld once said “There are known knowns; things we know we know. There are known unknowns; things we know we do not know. But there are also unknown unknowns – things we don’t know we don’t know.

Volatility falls into the known unknown category because we can’t really predict future volatility, what we can make reasonable guesses about is its future range. When markets fell nearly 50% in 2008, I would argue that is not an example of risk, but rather an example of volatility. History tells us that 50% declines in the market will happen at least a few times in a century. Investing and assuming that can’t ever happen isn’t risk, its ignorance.

Risk, is an unknown unknown. Risk isn’t trading options, but rather risk is your options expiring worthless because the trading platform crashed and you couldn’t sell them in time.

Josh Wolfe puts it best, “failure comes from a failure to imagine failure.” This is the world that risk lives in.

The lessons of Hedge Fund Long Term Capital Management

Long Term Capital Management was an ultra-successful hedge fund that worked day and night to maintain secrecy in their portfolio management. They routed trades through multiple brokers so that no one could understand its bets. What they didn’t expect, or even consider was that an army of imitators had already pieced together a pretty good chunk of their strategy already. So Long Term Capital Management was managing a portfolio, that was being mimicked by an even larger portfolio that had been created by the many people copying them. This means, every single trade LTCM tried to make was incredibly crowded already, and when a position didn’t work out and LTCM had to retreat, there was no one to sell the position to.

No where in Long Term Capital Managements pricing models, and investment models did they plan for copycats bleeding them dry. THAT. IS. RISK. The unknown unknown.

Preparing for the unknown unknown

 I gave a few examples of risk above, and those are generally considered “black swans” or things that do not occur often. After 2020 though I have realized that black swan risk, is the only type of risk that actually matters! This type of risk is the only kind of risk that can’t be prepared for, and the only kind of risk that can cause catastrophic loss.

So, how do you prepare for something that by definition can’t be prepared for? Just like parenting, you do the absolute best you can. In the background my team and I do scenario planning, where we are thinking of absolutely everything we can and modeling the risk around it. I preach ample liquid savings, because cash gives you time to allow for recovery and promotes calm decision making, not panic. I search the flaws in our investment thesis not just daily, but multiple times a day. There will ALWAYS be future scenarios that we didn’t think of or prepare for, a global pandemic comes to mind. What is the harm in giving it a try though?