Fear of the Drawdown, et al by Stephen Duneier
Keep It Simple Stupid The larger an organization, the more complex it is, so it’s important that it is run as efficiently as possible. If you can achieve the same goal with 4 people rather than one hundred, you should make every effort to do so. Fact is, four portfolio managers whose returns are 40% correlated offer the same level of diversification as 100 PM’s who are 60% correlated. Although some CIO’s may convince you otherwise, building a team of uncorrelated portfolio managers isn’t as simple as picking individuals with different specialities. It requires that you recruit freethinkers and actively cultivate a culture of independence. Studies have proven that you can add as many individuals to a discussion as you’d like, but if the conversation is dominated by one strong personality, the benefits of those additional members are merely illusory. How much diversification did you get with the combination of a currency trader who shorted yen and the equity trader who liked the Nikkei, even if one did so via cash and the other with options? Uncorrelated returns require uncorrelated thinking and that doesn’t happen by accident. Fear of the Drawdown I’m a huge fan of (American) football. So many life and business lessons play out on the gridiron. The psychological phenomenon I find particularly intriguing is the inordinate pressure put on place-kickers in the final seconds of a game, and the burden they shoulder for a tight loss should they miss that final kick. The average game is played for 60 minutes, with roughly 130 total scoring opportunities scripted by 18 coaches and executed by 90 players. So why do analysts and fans spend so much time focusing on scoring opportunity number one hundred thirty in a tight game, but not in a blowout? It’s human nature.
The same thing happens in our business. Every trade is a potential scoring opportunity for you, and your opponent (ie the markets). The first 1% drawdown should evoke precisely the same response as the tenth 1% drawdown, for without the first one, the tenth one wouldn’t be possible. Now some will argue that in fact, you should be more vigilant when losses are piling up. Truth is, “more” is a relative term. If in response to a drawdown you suddenly decide to become more vigilant, by default you must have been less vigilant before. The better approach is to be hyper-vigilant at all times, but that requires a tremendous amount of effort and can be exhausting, which is why so many treat the tenth 1% differently.
High Beta Bonds If I tell you that I convinced a car dealer to take $5,000 off the sticker price when I bought my new car, how would you react? Well, if the car that popped into your head was a $14,000 Toyota Yaris, you’d think I was the world’s greatest negotiator.
However, if I tell you the car I just bought was the $1.6 million Koenigsegg Agera R, my stock would quickly return back to earth.
The graph on the left is the one most commonly used by analysts when they want to make the case that Emerging Market debt is too tight. It simply subtracts the ten year US Treasury yield from the EMBI+ (Emerging Market Bond Index Plus). Problem is, it also lacks the perspective of proportionality and understates the potential explosiveness of EM debt. The graph on the right, however, shows the relative relationship between the two investment opportunities. When the “risk free” rate is near 10%, a mere 13%, or extra 3% return is hardly enough to warrant taking on additional credit risk. Pull the RF rate down to 1% though and that additional 3% yield has many of those same investors salivating. Think of it as a sort of yield beta. The interesting thing about yield beta is that it has tremendous skew related to the direction of the underlying yield, but also to uncertainty itself. While some may connect my interest in being long EM rate volatility to the end of QE, they’d be misguided. In fact, I don’t buy into the unwinding story. Having said that though, I wouldn’t be disappointed if I were wrong in that assessment. It’d be an unexpected bonus. The real driver for me is the uncertainty surrounding Tropical EM policy as their Goldilocks decade comes to an end.
Hideously Gorgeous "Why don't others buy in-the-money options?" - Asked by a large Pension Fund manager
When I was a financial advisor with Drexel Burnham, back in 1987, I would occasionally recommend a premium bond to a client. I can't tell you how many times I heard, "My other broker gets me my bonds at a discount. I never pay a premium," in response. You may be snickering at the naiveté of the average investor, but you'd be surprised just how many institutional investors refuse to buy in-the-money options, and their rationale isn't very different from that of my old clients.
Market commentators, analysts, and salespeople are incentivized to be somewhat sensationalistic. They gravitate toward the extremes, because the human brain is naturally attracted to them. However, despite what CNBC and the like would have you believe, no matter how fat the tail end of a distribution, "nothing happens" or something very close to it, is usually the most likely outcome. Perhaps the inability of most to come to accept this truth can go a long way to explaining why the great majority of all options expire worthless and why in-the-money options are so unpopular.
"Navigating these challenging markets requires a consistent and sound decision making process. Bija is a thought leader in this area."
About the Author For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.
Mr. Duneier teaches graduate courses on Decision Analysis and Behavioral Investing in the College of Engineering at the University of California. His book, AlphaBrain, is due to be published in October 2017 (Wiley & Sons).
Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.
Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management. As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.
His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 60,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.
Bija Advisors LLC In publishing research, Bija Advisors LLC is not soliciting any action based upon it. Bija Advisors LLC’s publications contain material based upon publicly available information, obtained from sources that we consider reliable. However, Bija Advisors LLC does not represent that it is accurate and it should not be relied on as such. Opinions expressed are current opinions as of the date appearing on Bija Advisors LLC’s publications only. All forecasts and statements about the future, even if presented as fact, should be treated as judgments, and neither Bija Advisors LLC nor its partners can be held responsible for any failure of those judgments to prove accurate. It should be assumed that, from time to time, Bija Advisors LLC and its partners will hold investments in securities and other positions, in equity, bond, currency and commodities markets, from which they will benefit if the forecasts and judgments about the future presented in this document do prove to be accurate. Bija Advisors LLC is not liable for any loss or damage resulting from the use of its product.
Learn how Bija's proven, proprietary approach to decision making helps the world's top institutional investors generate better results.