Unavoidable Drawdowns

Plus! Dumb Money; Adversarial Environments; Coasian Bargains in Immigration; Asset Allocation; Lock-In; Diff Jobs

Byrne Hobart Byrne Hobart

Unavoidable Drawdowns

Nassim Taleb has written some wonderful books on risk, with a focus on the idea that we underestimate the most extreme risks—at an individual level, that means people and organizations speculating in cases where they can face ruinous losses, and at a societal level it means brittle supply chains and total reliance on technologies few of us can understand.[1] Taleb’s solution to our problem is an "antifragile" approach: position yourself to benefit from volatility, rather than betting against it, because volatility is inevitable.

But this raises an important question: when you try to address those risks, do you deliberately refuse to think about the absolute worst-case scenarios? It's important to do so. The possibility of total loss has a serious impact on the expected returns of any strategy, dragging it relentlessly closer to -100% with the passage of time.

Suppose you start with a pretty standard portfolio—you're using index funds to get exposure to a mix of bonds and equity; mostly equity when you're young and mostly bonds when you’re older. You set aside some money for fun stuff (maybe you buy shares in a company whose products you love, or short a stock whose CEO you loathe). And you allocate a little money to your emergency portfolio.

What does that emergency portfolio look like? It depends on the emergency you’re worried about:

But if you think through each scenario, it's actually a way to address a worse-case but not the worst-case scenario. Physical gold, for example, retains some of its value even if the financial system collapses. On the other hand, the old coins we have are often recovered from hoards that someone buried and never dug up, often because of war, famine, plague, or revolution.

Someone who hedges their career risk by shorting their competitors still runs the idiosyncratic risk that one of those competitors will triumph specifically by defeating their employer—imagine a Compaq employee, worried that the PC boom will fizzle, shorting Intel and that one overhyped software IPO from Redmond.

Buying inflation-protected assets still makes some assumptions about which forms of capital will have value, and the security of claims against them. Members of the early 20th century English upper class tended to have portfolios weighted towards land and government bonds, exactly what you'd buy if you were certain of disaster but uncertain about whether it would be inflationary or deflationary. But after the First and Second World Wars, they got the worst of both worlds: inflation high enough to devalue the purchasing power of their bonds, taxes high enough to render the real return from their land negative.

There is, of course, a place for thinking about risks that are extreme in the sense that they lead to a financial wipeout for you, but not so extreme that they lead to the end of the social order that underpins your assets. For one thing, volatility drag is real: every 50% drawdown requires a 100% gain to get back to even, so volatility has a cost even when average returns are high.

This has actually played out not just at the individual or firm level but at the country level: some nations that industrialized rapidly chose to accept extreme economic volatility as the fair trade for rapid growth. And in many cases this worked out; South Korea grew rich and prosperous on the back of some seriously scary recessions in the 80s and 90s, before downshifting to a more stable model. But other countries with investment-intensive, borrowing-fueled growth hit macro turbulence that was more than they could handle; Brazil's performance looked similar to that of South Korea for a while, but some of the country's recessions have been so deep that recovery to the previous peak took over a decade and recovery to the previous trend never happened.

But outside the bounds of mere macro volatility, sometimes The Great Leveler shows up and portfolio beta suddenly matters less than survival. There are portfolios that are built around this—a nice luxury apocalypse bunker is, at a certain point, just prudent asset allocation. This is really just a death metal cover of Piketty's thesis in Capital in the Twenty-First Century: if the returns on wealth exceed the growth of the economy, then eventually everything is owned by whoever has been able to accumulate a critical mass of assets, unless something happens to either a) radically redistribute the wealth, or b) to destroy most of it, increasing labor's share relative to capital.

But that destruction turns out to be quite temporary! China's communist revolution was one of the most thorough economic levelings in human history, one so effective that the children of the elite were actually poorer than average for a while, but then recovered and by the early days of China's opening-up, and were better-off than ever. Similarly, in the post-Civil War South, the descendants of slave-owning families ended up about as well-off as other rich people, even though their land was seized, their currency depreciated to nothing, and the source of their wealth was banned by the Constitution.

There are some intangibles that persist even after cataclysmic events, and that's ultimately the only form of tail risk diversification that matters in a truly bad scenario. We're always hedging within the universe of possibilities we consider realistic. But some of the options we have are a function of intangible assets—skills and personal networks—which can't be expropriated. (They can, in a worst-case scenario, be destroyed, but they can't really be seized and used by someone else.)

Giving some thought to risk management, at the personal and societal level, is important. But a key lesson of Taleb is that risk is inescapable, and that extends even to the worst possible risks. Making investment decisions, whether they're purely financial or focused more on how you spend time, means placing a bet on an uncertain future. Ultimately, your bets have to move in the same direction history does, whether you’d like to or not.

  1. It's hard to do the Fermi estimates with much precision, but it wouldn't be surprising if there were some critical information on at least one step in the modern chip fabrication process that only exists in the heads of a few dozen people, and that could only be recreated by a few hundred—noting that it's a combination of book knowledge, tacit knowledge, and organizational capabilities, and it's not as if the electrical engineering PhDs in Taiwan are reading special textbooks that no one at Intel or AMD has access to. ↩︎

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Elsewhere

Dumb Money

The term "dumb money" is a common pejorative that usually implies that there are many traders making the same bet based on either bad data or a lack of good data. But a broader way to think about it is that it's any class of valuation-insensitive investors—technically, the biggest category of "dumb money" is sophisticated institutional investors with too much leverage who have to drastically shrink or suddenly liquidate an investment. They're price-insensitive, and in a hurry.

One thing markets do is transmit reasonably-informed ideas into worse ones because those ideas have to get expressed imperfectly. For example, many investors have opinions on commodities, but aren't familiar with or don't have access to futures. So they use exchange-traded funds which systematically trade futures. This can lead to situations like what's going in in natural gas markets, where two ETFs, BOIL and UNG, own about 30% of the current month's contracts for natural gas. Betting on a commodity, especially one with wild seasonal fluctuations like natural gas, is partly betting on the direction of prices and partly betting on timing. ETFs simplify this, but that also means that they push more demand to whatever contract they're designed to buy. Traders can and do trade against this kind of demand, but the same seasonality means that each month's contract is a somewhat different fundamental bet, so the ETFs' trades can distort the market.

Adversarial Environments

The Diff has previously written semi-fondly about the crypto industry's attitude towards regulation. In one sense: for a product whose guiding ideology was somewhere between libertarianism and anarchism, and whose first killer app was mail-order narcotics, it's a surprisingly buttoned-up industry with an refreshingly friendly attitude towards regulations. On the other hand, one reason for this is the high attrition: the sloppy exchanges get hacked by criminals, and the well-run exchanges are sometimes run by financial criminals. And sometimes there's convergence: BTC-e was a crypto exchange focused on Russian users, which was seized in 2017. As it turns out, one of the exchange's operators was one of the hackers who breached Mt. Gox, another crypto exchange, leading to the latter's collapse. The magic of ongoing improvements in blockchain analysis means that the industry is always getting retrospectively dirtier even as it cleans up its act in the present.

Coasian Bargains in Immigration

Global trade depends on the fact that different countries have different comparative advantages, related to natural resources, physical capital, institutions, and historically contingent factors. This usually shows up with the trade of goods and services in the private sector, but sometimes public sector actions can highlight it. For example, the EU is offering Tunisia €1.2bn in subsidies and loans in order to reduce immigration from there to the EU ($, FT). One way to look at this is that Tunisia has a comparative advantage in supplying a basic standard of living to people within its borders; Tunisia's cost of living is about 40% that of France, so even with some frictional costs, €1 of public services can go further there. It's a Coasian bargain in another sense: the EU countries might prefer to have less immigration, or to have it happen in a more controlled way, but if the country that can make that happen is either less interested in accomplishing that goal, or ill-equipped to, paying them can be the most cost-effective approach.

Asset Allocation

CalPERS, the $442bn public pension, is considering adding up to $5bn to its venture allocation ($, FT). There are many moving parts to this: CalPERS' argument is that within the broader private equity category, venture tends to have better returns. But venture is also levered to tech in general, which has outperformed in the last decade. One of the difficulties in asset allocation is distinguishing between an increase in the average expected return for a category and an increase in the entry price for that asset.

But what's also going on is that venture funds are in an annoying prisoner's dilemma. Each individual fund wants to keep its assets marked based on where valuations were two years ago, when they were deploying substantially more capital. But one result of that is that since public equities and bonds have declined, investors are more overweight venture than they were before, and getting back to even means writing smaller checks to venture funds, or skipping them entirely. And that puts more pressure on private company valuations, further growing the gap between the price at which they're held on the books and a realistic market price. So even if CalPERS' decision is not the right one on its own, it could be a self-fulfilling prophecy that pushes private company valuations up a bit and makes the market function better.

Lock-In

Apple is adding more OS-level features that create iPhone-specific interactions in apps. Part of Apple's strategy on the hardware side is to use tools like iMessage to get software-based lock-in ($, The Diff)—depending on how you attribute the incremental profits from new iPhone and Mac sales, iMessage is arguably worth $10s of billions, making it a fairly successful social network on its own. And once those economics work, the natural path for Apple is to extend them more.

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