Fragility and the Fat Tails

Finance Investing Risk Management Fragile

One of the most neglected discussions in all of finance regards fragility, which results in incredible volatility in the investing space.  Investors typically work to diversify portfolio holdings to mitigate the risks associated with a specific asset or region.  Generally, asset allocation has taken the form of either a traditional 60/40 split between stocks and bonds or followed Modern Portfolio Theory (MPT) by allocating capital to various sources of historic return.  Unfortunately, both of these methodologies have fallen short because (1) MPT is a superior method to the traditional 60/40 split and (2) investors have misapplied MPT by allocating capital towards sources of return when MPT designed to allocate towards sources of risk.  While the difference in performance might sound nuanced, in practice it has turned out to be night and day.  When MPT is appropriately applied, volatility and max loss drop considerably and returns are held constant or often enhanced.  Our firm has put a great deal of work into constructing portfolios that apply MPT correctly and, frankly, I know of almost no other firms doing such.  In fact, very few people in the industry or even within academia know of this distinction.

A second aspect to a fragile investment environment is that even when everything is carefully crafted and well-designed unforeseen events still threaten to derail everything.  The threat of a recession, depression, terrorist activity, hyperinflation, resource scarcity, pandemics, war, etc. all pose threats not only to your personal wellbeing but to your wealth.  Industry professionals refer to these and events as tail risk.  Graphed on a distribution curve these events typically hold a low probability of occurrence.  One of the more interesting aspects of the financial markets is that tail risks do not follow a natural distribution curve of risk but rather one where the tails are fatter, meaning that low probability events occur much more frequently (see chart below).

It is important to understand that fat tails impact every single asset you could own.  Nothing is safe from the carnage of fat tails; real estate, commodities, currencies, treasury bills, stocks, collectibles… everything is vulnerable.  Take for instance Greece. As the government flooded its economy with fresh capital, stocks dropped 70% while the currency dropped another 60% against other currencies.  In Russia, at the fall of the Soviet Union, both their stock market and currency fell to zero.  So if one thing didn’t wipe you out the other did.  While many look to gold or real estate as the ultimate safe assets, these are no panaceas.  Over the last week, gold has shed 20% of its value and throughout the 80’s and 90’s gold did nothing but lose money.  Similarly, real estate typically underperforms during rising interest rate environments or during periods of great inflation or population drops.

An ideal portfolio should not only help generate good returns for a unit of volatility but also give you some assurances against tail risk.  Institutional investors work aimlessly at guarding against tail risk while retail investors generally give it little thought.  One way to do this is through complex and expensive option strategies. Another, much more simple way to do this is though the correct application of MPT and understanding how different types of assets respond to different environments.  For more background on the topic, check out Nassim Taleb’s books “The Black Swan” and “Antifragile”.

 

[Photo: jose.jhg/Flickr]

This article was originally featured in the Bellingham Business Journal.