Saturday, March 07, 2020

The Single Greatest Life Lesson I've Learned From Markets

The single greatest life lesson I've learned from markets is that risks are not normally distributed.  The odds of very good and very bad outcomes are greater than they would be in a perfectly normally distributed world.  It's the presence of these "fat tails" that shape sound risk management.  We have to take risk to earn reward, but we have to manage risk to stay in the game long enough to reap our reward.

What that means in practice is that, wherever possible, we reduce or eliminate our tail risk to prevent catastrophic outcomes.  A simple example would be purchasing insurance on our homes.  No one complains about money "wasted" on home insurance just because our houses don't burn down or blow away in a tornado.  Similarly, we insure ourselves for hospitalization and routine healthcare even if we're perfectly healthy at the time.

On the other hand, we want exposure to the fat positive tails wherever possible.  It's that asymmetric exposure to positive versus negative outcomes that characterizes good portfolio management.

Many years ago, I changed jobs because I perceived that the workplace was not being managed properly and would eventually suffer because of it.  The tail risk, I believed, was greater than usual and I didn't want to be out of a job before finding a new one.  The position I moved to was growing significantly and there was a positive tail probability of growing within that company.  I learned those career moves from my time in financial markets.

When news of the coronavirus first hit in mid-January--and online mentions began to skyrocket, especially overseas--we did not yet hit our all time highs in the U.S. stock market and such precautions as hand sanitizer, nitrile gloves, and N95 respirator masks were readily available.  At the time I took such precautions, I was told that I was "overreacting".  From a risk management perspective, however, I was purchasing insurance.  I learned that, too, from trading markets.

Now, given the poor job of testing at-risk populations for the virus in the U.S. and new CDC advice for vulnerable populations to stay at home as much as possible, I'm taking further precautions and reducing time spent in public places.  Again, I'm told I'm overreacting.  What I'm doing, however, is managing my life the way I manage my investment portfolio, prioritizing staying in the game in order to eventually win the game.

The greatest life lesson I've learned from markets is to first mitigate risk, then aggressively pursue reward.

To be sure, there's a time to "go for it".  When I left a secure position at a medical school to work full-time with traders, it was quite a gamble.  I made sure I had a Plan B if the move to financial markets didn't work out and that allowed me to go all out to reap positive returns if things worked out well.  Similarly, in the current market, there is going to be a monster opportunity in stocks once it starts to become clear that the virus situation is abating.  With Treasury rates driven to all-time lows and the lack of yield in fixed income instruments, companies with strong balance sheets and decent dividends will become the new bonds.  There is a risk in ignoring the left tail of negative outcomes, but there is also a risk in not pursuing right hand opportunity tails as they become more probable.  

Good risk management is necessary for success, but not sufficient.  We also need good reward management.

The challenge of the current environment is that it calls for both.

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