No matter what kind of math you use, you wind up measuring volatility with your gut. – Ed Seykota
The difference between a good risk and bad risk is sort of like the difference between good pain and bad pain when you’re working out.
Good pain: You’re squatting your personal record and every fiber of your being is saying drop it, and your head is exploding and you’re making weird grunting noises and you just might vomit or soil yourself, but you keep going for one last rep with correct form and you feel major burnout and yet you feel great, because you know that is the burn that means progress. (I hated squats when a trainer tried to make me do ‘em.)
Bad pain: You feel a little off today and you’re just going through the motions and you jerk it, instead of that perfect form you were taught. And then something in your back tightens up, and you suddenly get that feeling, uh-oh, I might not be able to tie my shoes tomorrow.
No pain no gain. What doesn’t kill you makes you stronger, as Nietzsche said, shortly before he died. But how do you learn the difference between the pain that makes you stronger and the pain that might kill you?
In Band of Brothers, on the DVD extras, Carwood Lipton talked about attacking the guns at Brécourt Manor with 12 soldiers under Dick Winters, vs. about 60 Germans. That seems like a bad idea to start with. (Allegedly, HQ ordered Dick Winters to take out the guns, believing he had hooked up with most of his still-scattered Easy Company). Winters ordered Lipton to lay down covering fire, so he climbed a tree and started shooting down at the Germans in the trenches. With clever tactics of isolating the guns and storming them aggressively one by one, the small group took out the gun battery with minimal casualties. But the older and wiser real-life Lipton interviewed 50 years later for the DVD said that later in the war he would never have climbed that tree, he was far too exposed.
Canadian Tommy Prince was in an Italian farmhouse as an observer to direct shelling, when a shellburst cut his phone line. He put on the Italian farmer’s clothes, went out like a farmer and inspected the chicken coop, and shook a fist at the Germans and the Allies. Then he leaned down as if to tie his shoelace, spliced the wire, and went back to directing fire on the Germans. Incredibly bold. But if you think about it, a tactic that probably reduced his risk profile vs. hunkering down incommunicado or making a run for it.
Bad risk: You keep doing that, you’re going to get killed.
Good risk: Gives you the best chance to survive and prosper over the long haul.
|Good risk||Bad risk|
|Simple to understand what the risk factors are, frequency and severity of bad outcomes, how they interact with the rest of your portfolio.||Complicated, insufficient history to gauge frequency and severity of bad outcomes, possibility of a ‘catch.’|
|Good economics: properly compensated for the risk.||Bad economics: poor reward for the risk profile.|
|Just because economics are good and you can get paid doesn’t mean you will get paid. Counterparties you can trust, who have limited ability to rip you off, and whose incentives are aligned with yours.||Sketchy counterparties, with opportunities to change the terms of the deal, who have conflicts of interest, and who don’t care if you make money. Company managements can self-deal, sell out cheaply to a PE firm for rich management contracts. Financial counterparties can find fine print and fees to rip you off.|
|Risks asymmetrically skewed to the upside. Positive optionality/convexity. Limited downside, unlimited upside. Cheap long calls.||Risks asymmetrically skewed to the downside. Negative optionality/convexity. Limited upside, unlimited downside. Cheap short puts. Bonds yielding 0%. Picking up pennies in front of a steamroller.|
|Naturally a hedge or diversifier – uncorrelated or negatively correlated with the rest of your assets under most scenarios. Positively correlated with your real liabilities.||Texas hedge – positively correlated with your portfolio, negatively correlated with your liabilities.|
|Volatile short term, gives you the best chance of coming out ahead in the long run.1||Profitable short term, strong momentum, inevitably going to blow up at some point in the future.|
How do you tell which side of the line you’re on? You’re not going to know the difference your first day out. You need a system2 that limits the risk you take. You need to do some math, either simple or complicated, that gives you an idea of the frequency and severity of bad outcomes or periods. And you need experience. The little voice that tells you, something has changed, those assumptions that you built into the system aren’t right for current conditions.
And risk is subjective on some level. Just because you won doesn’t mean it was a good bet. Maybe you got lucky. Conversely, just because you got hurt doesn’t mean it was a bad bet — maybe you got unlucky. The question is, was that the best risk-reward play? And in the long run, if you keep doing that, are you going to come out OK? Even a bet with positive expected value is a losing proposition in the long run if you bet too big. (The gambler’s curse.)
Regardless of how subjective risk is, poker players know who is dead money at the table, even if they flop the nuts once or twice. Scouts know some athletic phenoms are not going to have a long career because they don’t have good fundamentals or work ethic. Time and the law of large numbers and the central limit theorem convert the highly variable in the short run to the more predictable in the long run.
George Soros claims he has developed a sixth sense for when something isn’t right with his positions, and he starts to feel physical back pain when he is not comfortable with his positions and tenses up. And yet he also famously said “it takes courage to be a pig.” When you’re right on something, you want to be be positioned to extract maximum value from being right.
Risk, pain, intense effort: instinctively we shun them. But your ability to face them with a healthy attitude determines your personal growth and success. We need to learn to appreciate the right kind of pain and risk and distinguish it from the wrong kind.
Risk is your friend when you’re getting paid the right price to take it, you put on the right amount in the context of your entire portfolio, lifestyle, expectations, and personality; and you monitor and manage it by diversifying and cutting when necessary. Confidence is when you know what the worst case is and that you can handle it. When in doubt, get out, or limit your potential losses to what you can handle.
Volatility matters when you feel it. All the charts, ratios, and advanced math in the world mean nothing when you break down, vomit or cry due to the volatility in your portfolio. I call this the vomitility threshold.. Understanding your threshold is important, for it is at this point that you lose all confidence and throw in the towel.
- Ed Seykota
Man cannot remake himself without suffering, for he is both the marble and the sculptor. – Alexis Carrel
2 The “system” doesn’t need to be complicated. It could be as simple as a robo-adivsor portfolio or a lazy portfolio. Or it could be a full-blown active trading system with criteria for market selection, position sizing, entries, and stops/exits. But regardless, you need to keep in mind what assumptions were made in picking the system and monitor that things haven’t changed in an important way, including your own life situation and risk tolerance, and market conditions which change the risk/return profile, such as a 1999 type tech bubble or current day ZIRP interest rates.