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.

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)

Ode To Liquidity

When it comes to risk management there is one consideration that towers over all the others. That is liquidity.

The word “liquidity” can mean different things in different contexts. Sometimes it literally means “cash.” Other times it refers to your ability to quickly convert the full value of another asset (like a stock or a mutual fund share) into cash. This post will reference liquidity in both contexts.

Liquidity (“cash”) is the lifeblood of our financial lives. It is the medium through which we move consumption forwards and backwards in time. It is the bridge that links spending, saving and investment.

You don’t fully appreciate the importance of liquidity until you need it and don’t have it.

Poor people understand this intuitively. For a poor person life is a never-ending liquidity crisis. It is the global financial crisis on repeat. There’s a reason the foundation for all financial planning is the net cash emergency fund. The net cash emergency fund is your liquidity buffer. It’s loss-absorbing capital. It’s what keeps you from getting caught in the vicious cycle of dependency on short-term, unsecured, high cost debt like credit cards and payday loans.

Funnily enough, there are plenty of rich people who live life on the edge of a liquidity crisis. Some of these people have a large amount of their net worth tied up in real estate or private business ventures. You can have a lot of paper wealth but still very little liquidity.

When the shit hits the fan, your paper net worth is irrelevant. If you don’t have enough cash on hand to meet your financial obligations, you are toast. This is the story of every banking crisis in the history of finance.

Sure, you can sell the illiquid things you own to raise cash. But that takes time. And the less time you have to sell the worse your negotiating position gets.

There is nothing a shrewd buyer delights in more than finding a forced seller who’s running out of time. This is the essence of distress investing. Distressed investors are often able to buy good assets for fractions of their value because the sellers are desperate for liquidity.

Does this mean you should never own illiquid things?

No!

It means you should never assume you will be able to sell an illiquid thing at a favorable price at a place and time of your choosing.

As an individual, how do you know if it’s okay to own an illiquid thing?

If you can write it down to zero the moment you buy it, and it will not impact your ability to make good on your day-to-day obligations, it is okay to own the illiquid thing from a liquidity standpoint. The thing may still turn out to be a terrible investment, but that’s a separate issue.

These days there are lots of things being marketed to regular folks that are illiquid things disguised as liquid things. These are things like interval funds–the mutual fund world’s answer to private equity. These are also things like non-traded REITs with redemption programs that allow you to withdraw, say, a couple percent of your investment every quarter.

Perhaps your financial advisor has pitched one of these things to you.

Read the fine print!

The underlying assets in these funds are illiquid, and the fine print always allows the investment manager to suspend your redemption rights. Third Avenue Focused Credit investors thought they had daily liquidity, like in any other mutual fund.

Ask them how that worked out.

The Alchemy of Risk, Revisited

In a meeting last week an asset manager predicted that whenever the next major market drawdown occurs, a massive central bank intervention will immediately follow. This will prop up asset prices. The drawdown will be brief and v-shaped.

Th natural follow-up question: how long can this go on?

In theory, of course, it can go on forever. As long as market participants are willing to believe in the infallibility of ever-wise and benevolent central bankers, the Fed can effectively outlaw market crashes.

But that implies central bankers can somehow destroy financial risk. We know from market history risk can never be destroyed. It can only be transformed and laid off elsewhere.

So, what kind of risk transformation underlies this process?

What’s happening is financial risk is being transformed into political risk. Or, if you prefer, market volatility is being transformed into political volatility.

In an old Epsilon Theory note, Ben Hunt describes central banks as “creatures of capital:”

Not to get all Marxist here, but these vampires share the DNA of Capital, in opposition to the DNA of Labor, and this is why you will never see the Fed or any other central bank lift a finger against them. Because the Fed is also a creature of Capital — not a vampiric destroyer as these modern manifestations of Capital have become — but a creature of Capital nonetheless.

Meaning what, Ben? Meaning that all of the Fed’s policies — and particularly the monetary policies that are most impactful on our investment portfolios — are in the service of Capital. Sometimes, as we’ve experienced over the past eight years, that means incredibly accommodative monetary policy to support asset collateral prices. Sometimes, as we’ve seen in the past and I think we’re about to see again, that means punitive monetary policy to crush labor and wage inflation.

Pop quiz: What do President Donald Trump and Alexandria Ocasio Cortez have in common?

Answer: They’re creatures of Labor.

In the case of Trump that might seem like a controversial statement. But think about it. Do trade barriers serve Capital or Labor? Does restrictive immigration policy serve Capital or Labor? Cheap imports and immigrant labor sure are good for Capital. Not so much for Labor.

There’s certainly more nuance to it than that. There’s an argument to be made that Trump merely duped the voting public into seeing him as a creature of Labor. But for the purposes of this post that’s irrelevant. In politics, all that matters is what the crowd believes. (Enough of the crowd to sway an election, anyway)

Trump speaks the language of Labor in front of crowds of steel workers and the like who have spent decades on the pointy end of globalization. Likewise when Ocasio Cortez talks about “economic dignity” she’s speaking the language of Labor.

The way Labor traditionally puts the hurt on Capital is through collective action. Ideally that’s political participation and modest civil disobedience. But in the worst cases it’s violent revolution. (Talk about tail risk)

Speaking of tail risk–a similar dynamic is afoot in China.

China’s economy is more or less run as a closed system. This is extremely important for the CCP, which needs to be able to push imbalances around the system to keep it from collapsing. There’s an argument to be made that the Chinese economy is a perpetual game of whack-a-mole with the CCP always needing to pop a bubble here and let another one inflate there.

This is another dynamic that can in theory go on forever but for villagers-with-pitchforks risk. There’s a practical reason the Chinese government has constructed a massive surveillance state.

It’s the tail hedge.

Your Risk Analysis Sucks

Yesterday I was discussing some risk analysis with a colleague. Specifically, quantitative risk scores for fixed income funds. The details of the scoring are not important for the purposes of this post. Suffice it to say it is along the lines of sorting funds into quartiles based on statistics such as rolling volatility and drawdown.

The point of our discussion was that soon the financial crisis period will roll off the risk scores, penalizing more conservative portfolios in the ranking system. The scores will implicitly reward excessive risk-taking.

This is a great metaphor for the state of markets today.

Collectively, we have forgotten what it means to be afraid. Today, it is all about squeezing as much return as possible out of a portfolio. Fear has rolled off our collective memory. And what’s worse our lack of fear is justifiable according to the trailing 10-year data.

This at a time when:

  • Credit spreads are tight.
  • Covenants are weak.
  • Leverage is high.
  • Oh, and interest rates are rising.

There is an inherent tension in risk management between simple statistical measures (which people prefer) and the true nature of risk (which is nuanced and difficult to quantify). In fixed income in particular, the payoffs are negatively skewed. As an extreme example: “I have a 94% chance of earning a 6% yield on my $100 principal investment and a 6% chance of losing the $100 of principal.” Only in real life we don’t know the probability of default in advance.

The standard deviation of a high yield bond fund does not do a great job of describing its risk. In the absence of defaults the volatility will be fairly mild. If defaults tick up in a recession, losses could be catastrophic–particularly if liquidity dries up and twitchy investors decide to redeem en masse. None of the most significant risks to a high yield investment are properly captured by its standard deviation.

But people do not want to talk about conditional probability and expected losses given default and the uncomfortable fact that their financial lives are non-ergodic.

People want simple, black and white answers.

Statistical risk analysis is popular because it uses straightforward inputs and is easy to run at scale. Looking at a portfolio and puzzling out how it might behave in future states of the world, without relying on correlation and volatility statistics, takes a lot of time and energy. It is a “squishy” process. Your peers might think you are a bit of a crank because you aren’t sufficiently “data-driven.”

Oh, and much of the time things will run smoothly anyway.

Diligent risk management is a thankless task. No one pats you on the back for the things that didn’t go wrong. In fact, in a market environment like this one, a little extra prudence can get you fired.

This is why cycles happen. People forget that a little fear is healthy. Or, more precisely, the market environment conditions people to invest more aggressively. They overreach (their backward-looking risk analyses encourage it!) Then when the cycle rolls over they get slaughtered.

Whenever I am looking at an investment one of the things I think long and hard about is under what conditions it might explode spectacularly like a dying star. Excluding fraud, these kinds of blowups are generally caused by leverage (too much debt or financial derivatives with embedded leverage a.k.a convexity) and asset/liability mismatches.

It should be fairly straightforward for a competent analyst to identify and control these risks. More importantly, as analysts we should be getting these things right more often than not as they are triggers for catastrophically bad outcomes. What’s more, none of them is captured by backward-looking statistical measures.

The Alchemy of Risk

Here is a recurring theme from this blog: “risk can never be destroyed, it can only be transformed and laid off on someone else.”

Or, in the words of the late, great Marty Whitman: “someone has to pay for lunch, and I don’t want it to be me.”

Often people think they’ve destroyed risk when they buy a financial product with a guarantee attached. In finance, “guarantee” is just a fancy word for “promise.” When you buy a financial product with a guarantee attached, you’re swapping market risk for something else. Usually it’s a stream of payments with its own set of risks.

The person selling you the stream of payments will tell you that you’ve gotten rid of your risk. And you have, to an extent. You’ve gotten rid of A risk. You’ve traded your market risk for credit risk (your counterparty might not make good on their promise) and purchasing power risk (your stream of payments might not keep up with inflation).

Some of you will say, “but the counterparty is contractually obligated to keep is promise!”

To which I say, “so are bond issuers and individual borrowers. Yet they default all the time. Sometimes they even commit fraud.”

Others will say, “you don’t know what you’re talking about! The government has insurance funds for deposits and pensions!”

To which I say, “promises, promises, all the way down.”

How does the government fund its promises? With tax revenue, partly. But more importantly, with debt. Like I said–promises, all the way down. Dollar bills are themselves promises. What is the “full faith and credit of the United States government” but an elaborate series of promises?

Anyway, for normal people the most common example of “risk transformation” would be buying an annuity or whole life policy from an insurance company. But there are more exotic examples.

Banks like to sell structured notes to their wealth management clients. These are difficult products for the average person to understand. They usually promise a return based on the price performance of some index, subject to certain limitations. For example there will be a guaranteed minimum return and a cap on the high end.

(Notice that I said price performance. If you buy a structured note, no dividends for you!)

Banks like this opacity because the complexity makes it easy for them to bake profits into the structures, which are literally designed by mathematicians (actuaries). The products are sold based on the guaranteed minimum return, and the chance of modest upside. As the buyer, you overpay for the downside protection (the guarantee). When you buy a structured note, you are basically lending the bank money so it can write options and eke out some trading profits. In return you get a more bond-like risk profile.

Meanwhile, you are an unsecured creditor of the bank. If the bank goes bust, your investment is toast. So much for guarantees. Get in line with the rest of the unsecured lenders. Ask the people who bought structured notes from Lehman Brothers how it worked out for them.

In general, the more complicated the product, the worse a deal you are getting. Of course, there can be good reasons to swap market risk for a guaranteed stream of payments. Just because you overpay for downside protection doesn’t make you a sucker.

But lunch is definitely on you.

“To the moon!”

From The McKinsey Global Private Markets Review 2018 (subtitle: “The rise and rise of private markets”):

McKinsey_PE_Rocket_Ship
Source: McKinsey

Your eyes do not deceive you. That is literally a rocket ship with stabilizer fins made of dollar bills, blasting off into the stratosphere. I like to imagine it’s headed off to join the crypto people and their lambos on the moon.

A few highlights from the introduction:

“Private asset managers raised a record sum of nearly $750 billion globally, extending the cycle that began eight years ago.”

“Within this tide of capital, one trend stands out: the surge of megafunds (of more than $5 billion), especially in the United States, and particularly in buyouts.”

“What was interesting in 2017, however, was how an already powerful trend accelerated, with raises for all buyout megafunds up over 90 percent year on year.”

“Investors’ motives for allocating to private markets remain the same, more or less: the potential for alpha, and for consistency at scale.”

This is what you see when an asset class gets frothy. And private equity is an asset class I have had my eye on for a while now. As I have written before, and as McKinsey says somewhat obliquely in their report, institutional investors have come to view private equity as a magical asset class.

We have seen this movie before. It happened with hedge funds in the early 2000s (spoiler alert: it ends with capital flooding into the space and diminished future returns). There are no magical assets. People ought to know better by now. I guess the allure is too powerful. Particularly for return-starved pension systems.

Anyway, when this thing turns there are going to be knock-on effects in a couple of other areas: namely high yield debt and leveraged loans. The gears of the private equity machine are greased with high yield debt. These days there is a strong bid for crappy paper. Especially crappy paper with floating rates.

The yield on the S&P/LSTA US Leveraged Loan 100 Index is something like 5%. Meanwhile, 2-year Treasuries yield 2.5%. And loan covenants suck, which means when defaults inevitably tick up recoveries are going to suck. Buyers are so fixated on interest rate risk they’re overlooking the credit component. You can keep your 250 bps of spread, thanks. Doesn’t seem like a great risk/reward proposition to me.

If I were a big institution, I would be swimming damn hard upstream against consensus on private equity.

If I were a financial advisor, I would steer clear of floating rate paper, rather than reach for a bit of yield so I can tell my clients they’re insulated from interest rate risk.

If I were a distressed debt investor I would make damn sure I had access to liquidity for when these deals start to explode (indeed, many distressed funds are out seeking commitments for exactly this purpose).

The institutional investors will screw it up, because they’re organizationally incapable of swimming upstream. Most of the financial advisors will screw it up, too, because they don’t really understand what they own in a bank loan fund and they tend to fixate on past performance data, which isn’t as relevant to the current environment. The distressed debt guys and gals will make a bunch of money for a few years picking through the shattered ruins of these deals. That, I admit, warms my heart. The distressed folks have had a rough go of it lately.

This whole dynamic is a great example of how investor psychology drives market cycles. To play off that tired old hockey analogy: investors don’t skate to where the puck is going, they skate toward the player who last handled the puck.

Here the puck is going to stressed/distressed debt.

It is most definitely not going to the moon.