The Best Risk Questionnaire (Bonus: It’s Free!)

Answer the following questions with complete honesty:

  • Did I buy equities in October and/or November of 2018?
  • If so, what did I buy?
  •  Why?

This exercise will give you a pretty good idea of how you handle market volatility. Not in a theoretical, highly-abstracted, mean-variance optimized way but in the visceral OH-MY-F*ING-GOD-this-stock-I-own-just-fell-40%-WTF-do-I-do-now?!?!? kind of way.

In other words, this exercise gets you thinking about risk in the only terms that matter.

Many people have told me, “oh when the market goes down stocks are on sale so I buy. Buffett says to be greedy when others are fearful.”

Most of them are liars.

People overstate their risk tolerance in bull markets. Ask the crypto people how much time they spent thinking about risk last December. Ask the FANG cheerleading section how much time it spent thinking about risk in 1Q18. I bet if you’d given these investors risk questionnaires they would’ve come back showing an extreme willingness to take financial risk. Everyone feels like Warren Buffett when the tape is printing big, fat green numbers day after day.

In the financial advice business we like to pretend we can put neat little numbers around people’s risk tolerance. We give them risk questionnaires or gussied-up, Millennial-friendly versions of risk questionnaires to match them with a model portfolio that ultimately ends up being the usual 80/20 or 60/40 or 70/30 mix you’d give someone just from eyeballing her age. Maybe we go 50/50 if she seems particularly elderly and infirm.

All of this is nonsense. It is scientism.

The way you measure someone’s true risk tolerance is to look at how they’ve allocated real dollars of their hard-earned cash. If a prospect shows up in your office with $500,000 in a bank savings account and no equity investments whatsoever, you’re dealing with someone who doesn’t like taking risk. If someone shows up with $1,000,000 of a $2,000,000 portfolio in small cap biotech stocks and another $500,000 in rental properties with a bunch of debt on them you know you’ve got a gunslinger on your hands.

Simple. Easy. Robust.

Yes, guy in the back, I can hear you muttering something under your breath about “investor education.” “Some of those people with $500k sitting at the bank just don’t understand investing and that’s why they sit in cash.” So what? Their willful ignorance further underscores their risk aversion.

People who are extremely tolerant of financial risk seek out risk on their own initiative. In business we call these people “entrepreneurs.” They may sometimes take risk in stupid ways, by reading scammy stock newsletters or buying a bunch of Litecoin or whatever, but their propensity for risk taking clearly manifests itself in their portfolios.

To steal blatantly from Taleb, this is a “skin in the game” thing.

Ignore what people say.

Pay close attention to what they do.

Reaching For Yield

Are you a high net worth individual investor?

Are you feeling left out of the institutional yield chase?

Do you wish you could access the same esoteric, illiquid credits as pension funds and endowments?

If so, we may just have an investment opportunity for you.

Interval funds offer you, the high net worth individual, the full institutional investing experience. Not only do you get the high management fees and carried interest associated with traditional private equity investments, but as an added bonus you will invest through a seemingly liquid, mutual-fund like structure that is in fact subject to the vagaries of market conditions and the fund sponsor’s judgement.

That’s basically the pitch for interval funds. Interval funds are part of a larger growth trend for private credit and direct lending funds. Remember all the risky loans banks used to make prior to the financial crisis? Well, banks don’t make those loans anymore. They have regulation to thank for that. The risky loans didn’t go away, though. They just moved from bank balance sheets to private credit vehicles–unregulated hedge fund and private equity-like structures.

Up until recently private credit has remained out of reach of most individual investors. Interval funds are now being marketed as a way for a wider array of individuals to access private credit and even private equity. The idea is that a sponsor with expertise in these areas (like Carlyle) can sub-advise on a strategy that can be sold through a large asset manager with established retail distribution channels (like Oppenheimer Funds).

As you might guess I have several issues with interval funds. Here are the main ones:

  • You have know way of knowing whether the sponsor actually cares about performance or is just dropping mediocre deals into the structure to gather assets in a high fee product. I struggle to believe these sponsors are saving their choice deals for interval funds when they have longtime relationships with large, institutional investors to look after.
  • Illiquid things are being held in what is being marketed as an open-ended structure. This works right up until it doesn’t. In the event of a severe market dislocation these funds will suspend their repurchase programs and investors will be stuck.
  • In my view, you’re not being compensated particularly well for the risks you’re taking. Don’t take my word for it. Read the financials. Maybe you think 500-ish bps of spread is fair compensation for this kind of risk. Fair enough. But consider that JNK will give you nearly 400 bps of spread over 10-year Treasuries these days.

Here’s what the portfolio valuation disclosure for the Carlyle/Oppenheimer vehicle I’ve been linking to above looks like:

OPCIX_ASC_820
Source: OFI Carlyle Private Credit Fund Semi-Annual Report

This would be pretty typical for a private fund playing in credit such as a credit hedge fund. I have a mental rule of thumb for these things which goes like this: in a dislocated market, assume the fund will turn completely illiquid. Do not invest unless you’re prepared to live with the consequences.

The sales pitch for interval funds is straightforward. It’s yield!

There’s a pejorative term in the business for investors who chase yield without regard to risk. We call them yield pigs. And yield pigs almost always end up getting slaughtered.

Time to go long Bitcoin?

It’s fashionable these days to dunk on Bitcoin and cryptocurrency more generally. Charts like the one below lend themselves to dunking. And I must confess some schadenfreude as certain crypto shills and charlatans get some well-deserved comeuppance.

181130_BTC_1YR_Chart
Source: WorldCoinIndex.com

I’ve written about crypto on several occasions on this blog. While I’ve enjoyed following the space from a distance, I’ve never put real dollars on the line. As I wrote last year in my Bubble Logic post, I just can’t get my head around how to judge when the stuff is cheap or expensive.

Are cryptocurrencies actually worth anything? If so, what are they worth?

I took a stab at this myself not too long ago. It was a useful exercise although it did not exactly end with concrete results. So despite having learned even more about blockchain and cryptocurrencies in the meantime, I remain stuck.

How am I supposed to invest in something that I cannot value?

Now, there is a pragmatic solution I have not really discussed (also mentioned by one of Patrick’s interviewees). That is, you can simply look at cryptocurrencies as call options (or, if you prefer less financial jargon, as lottery tickets). Viewed through the lens of portfolio construction this is far and away the best way of approaching the problem given the dramatic skew in the distribution of potential returns. Max downside is 100% of the original investment. And max upside is what? A 1000x gain? More? That is a pretty attractive option.

Yet it still doesn’t sit right with me. It feels too much like gambling. Which isn’t the worst thing in the world. I enjoy the occasional trip to the casino. However, conflating investing and gambling does not seem like a real answer. In fact it seems like bubble logic: gamble a little so you won’t miss out and regret it.

I wrestle with the same dilemma today.

On the one hand, the narrative around crypto has definitely shifted. It’s gotten extremely negative. I’d say it’s bordering on capitulation. If valuing this stuff were as straightforward as valuing stocks, it would be time to go bargain hunting.

Unfortunately, valuing crypto is not as straightforward as valuing stocks. You don’t have cash flows to look at. You don’t have hard assets to look at. All you’ve got is supply and demand.

For what it’s worth, I don’t believe Bitcoin is a zero. Bitcoin is ultimately a faith-based asset. It has value to the extent other people believe it has value. There’s probably always going to be at least some subset of the population that believes Bitcoin has value. But as a potential investor, I have to suss out whether the size and enthusiasm of that faith community translate to a price of $0.001, $1,000,0000, or something else entirely. Then I have to assign probabilities to those outcomes. That’s simply not something I’m able to do with any real confidence.

That said, I’m not ready to write all crypto off as an investment fad or fraud.

I’m interested in applications for distributed ledgers that aren’t built on a narrative of “get rich or die tryin’.”

I’m interested in crypto (and Bitcoin specifically) as a potential financial hedge against kleptocracy and economic mismanagement (China, Zimbabwe, Venezuela).

I’m interested in crypto’s potential to democratize and decentralize the issuance and trading of securities that can be valued using traditional means.

I do think crypto is here to stay, in some form or fashion. But I’m still not prepared to make financial bets on those outcomes.

Mad Scientist Futurists

“Any sufficiently advanced technology is indistinguishable from magic.” –Arthur C. Clarke.

In my line of work, I sit in a lot of meetings. I listen to a lot of conference calls. I attend a lot of conferences. Many of these are thinly disguised sales presentations. Sure, we don’t call them sales presentations. We call them “continuing education” or “maintenance due diligence” or “onsite manager visits.”

You sit through enough of these meetings and you begin to recognize different archetypes.

There’s The Brilliant Introvert.

The Streetwise Deal Guy.

The Mad Scientist Futurist.

That last fellow is most often encountered in group settings. Particularly conferences. I’d venture to say the industry conference is the Mad Scientist Futurist’s natural habitat.

Now, the guy doesn’t necessarily predict the future. He might merely describe a possible future. These days, for example, the future seems to involve a lot of e-sports and e-commerce and machine learning. A few years ago it was drones and 3D printers as far as the eye could see.

The Mad Scientist Futurist spends a lot of time on his description of the future. And it’s not just him up there talking, mind you. He’s got sales collateral. He’s got data and charts and renderings. He does Science!, remember? After about fifty slides of this, it all takes on a certain aura of inevitability.

And then, finally, once he’s painted a sufficiently fantastical image of the future, the Mad Scientist Futurist tells you what the future means.

He tells you what it means for society. He tells you what it means for the economy. He tells you what it means for your portfolio.

The Mad Scientist Futurist is a modern incarnation of the wizard! meme. We seem hardwired to respond to wizards as symbols, both in stories and in life. Merlin is a wizard. Faust is a wizard. Elon Musk and Satoshi Nakamoto are wizards.

We have an innate weakness for wizards and Mad Scientist Futurists precisely because we’re hungry for meaning and Narrative. When we see magic advanced technology in action, our tiny minds can scarcely comprehend the implications. We want someone to walk us through them. We need someone to walk us through them.

This isn’t necessarily a bad thing.

But it can be dangerous.

Because memes and archetypes are so powerful, they’re easily weaponized to sell us stuff. The Mad Scientist Futurist is typically deployed to sell what the style box classifies as “growth” investments–expensive tech stocks and venture capital and such.

Now, there’s nothing inherently wrong with owning expensive tech stocks and venture capital and the like. But you should own it because you’ve made a conscious decision about the role it plays in your portfolio–not because a Mad Scientist Futurist cast a Buy! spell on you.

Needful Things

Satanic_Leland_Gaunt

Mr. Gaunt steepled his fingers under his chin. “Perhaps it isn’t even a book at all. Perhaps all the really special things I sell aren’t what they appear to be. Perhaps they are actually gray things with only one remarkable property—the ability to take shapes of those things which haunt the dreams of men and women.” He paused, then added thoughtfully: “Perhaps they are dreams themselves.”

–Stephen King, Needful Things

If your job is to sell people stuff, the path of least resistance goes something like this:

1)      Sell cheeseburgers to fat people

2)      Sell advice on giving up cheeseburgers to fat people

The point here isn’t to poke fun at fat people. The point is that “fat person” is an identity with a lot connotations attached to it. One might go so far as to call those connotations “baggage.”

Other identities with a lot of connotations attached to them include: “retiree,” “former executive,” “doctor,” and “little old lady who wants a good rate on her CDs.”

We’ve all got identities. We’ve all got baggage. We’ve all got cravings.

Salespeople know this.

I opened this with a quote from Stephen King’s novel. Needful Things. In the novel, Leland Gaunt sells trinkets. The trinkets take the form of something that matters to you. Whatever triggers your deepest desires and fears. And, of course, Leland Gaunt’s willing to give you a deal on that particular item. All he asks in return is a little favor…

You go into Leland Gaunt’s shop thinking you’ll shell out some cash for a trinket. A rare baseball card. A lampshade. A religious relic. But the true cost is your soul.

Investment products, too, are things that matter. They trigger powerful emotions. You come to associate them with your aspirations, hopes and dreams.

People who sell financial products know this. People who sell deals know this.

“Oh, so you’re a Little Old Lady Worried About The Market? We’ve got an equity indexed annuity for you.”

“Sophisticated allocator? I see private equity co-invests have caught your eye.”

“Tech entrepreneur? Have you ever looked at crossover biotech funds?”

The Leland Gaunts of the investment world traffic in symbols and memes:

Yield!

Diversification!

Innovation!

Security!

Sophistication!

Tax Breaks!

Deals!

I hate to break it to you purists, but most investments aren’t sold on the basis of future expected cash flows. Most deals are sold as little gray things that will satisfy whatever cravings you’ve got as a retiree or endowment CIO or little old lady looking for the best rate on a CD. Whatever matters to you, there’s a broker out there who will sell it to you.

And you’ll probably get a deal.

Caveat emptor.

 

(major h/t to Epsilon Theory for inspiring this post)

A Man’s Got To Know His Limitations

Lieutenant Briggs: You just killed three police officers, Harry. And the only reason why I’m not gonna kill you, is because I’m gonna prosecute you–with your own system. It’ll be my word against yours. Who’s gonna believe you? You’re a killer, Harry. A maniac.

[Briggs starts to drive away when the car blows up]

Harry Callahan: A man’s got to know his limitations.

That’s the end of the 1973 movie Magnum Force. Briggs, a vigilante cop, has an opportunity to shoot Harry Callahan dead. But Briggs is an egomaniac convinced of his own moral superiority. He opts for a clever revenge scheme instead. He flees in a car, which, unbeknowst to him, has a live bomb in the backseat.

A man’s got to know his limitations.

I was moved to reflect on this after a recent due diligence trip. In investing, outcomes are inherently uncertain. We never have perfect information when making investment decisions. We’re lucky to have “good” information in most cases. Even then, unexpected events have a nasty habit of blowing up our plans.

Investing is an exercise in probabilistic thinking. Outcomes do not necessarily reflect the quality of decisions (good investment decisions often result in bad outcomes and vice versa).

When investing, you’ve got to know your limitations.

If you’re a typical outside minority passive investor, you have minimal control over investment outcomes. Basically, the only variable you can control is your own behavior.

You need to be realistic about what you can and can’t know, and the kinds of things you should and shouldn’t expect to get right. The more you can expect to get a decision right, the more time you should spend on that area. Don’t waste time on things that aren’t knowable, or things subject to lots of random noise.

 

Things I Will Never Get Right

Forecasts for prices and other variables. (This would seem obvious but it never ceases to amaze me how much time and energy is wasted here)

Timing, in the sense of trying to buy the bottom tick or sell the top tick.

Macroeconomics.

Intrinsic value. (It’s not observable)

 

Things I Should Get Right More Than Half The Time

The general quality of a given management team.

The general quality of a given business.

Industry dynamics, competitive forces and secular trends.

The potential range of outcomes for a given investment.

 

Things I Should Get Right Most Of The Time

The handful of key variables that will make or break an investment.

How I’ll know if I’m wrong about any of the key variables that will make or break an investment.

Assessing the major “go-to-zero” risks: leverage, liquidity, concentration, technological obsolescence and fraud.

When to average down, when to hold and when to sell out of an investment, not based on price action but on the key drivers and risks.