The Concept of Risk
Below is an extract from a "subscriber's only" commentary originally posted at marketthoughts.com on 30th October 2005.
We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. For now, we are completely neutral and in cash. This author is still looking to initiate a 100% long position in our DJIA Timing System in short order - although the market still remains dangerous and uncertain at this point (even with the huge rally last Friday). Despite this short-term uncertainty, however, this author will have to concede that the bulls now have the upper-hand. Anyone that is still shorting the markets here has to be very careful.
In our last commentary, I discussed the recent appointment of Ben Bernanke as the new Federal Reserve Chairman - along with a discussion of his beliefs and the policies that he will likely follow in his term as Federal Reserve Chairman. I argued that he will be a very active Chairman - on curbing both inflation and deflation - and also making sure that the private sector has a very clear idea with the intentions of Fed policy going forward. Please keep in mind that the subjects of finance and risk are still relatively undeveloped. Recall that as early as the 17th century, the modern concept of probability and game theory was still non-existent. The popular thinking at the time was that the outcome of each dice game was solely dependent on the Gods. Modern finance, as stock market participants know it today, basically only emerged in 1952 - when Harry Markowize first pioneered the idea of the "Modern Portfolio Theory".
If folks like Ben Bernanke, Robert Shiller (with his somewhat utopian view of the world in the 21st century where all kinds of real-world risks can be hedged), George Soros (with his idea of "reflexivity"), Adam Smith (with his book on "The Theory of Moral Sentiments"), and Fisher Black have their ways, however, then we are still in the early days of Modern Finance, as well as our concept of risk measurement as we know it today. The Ben Bernanke Grand Experiment is now upon us, and it is going to be a very interesting and exciting ride, indeed.
As stock market participants, it is imperative that we can assess risk in the proper way. It is said that on the trading floor of Enron North America, the two must-read works were "Reminiscences of a Stock Operator" and "When Genius Failed: The Rise and Fall of Long-Term Capital Management" - two works which this author would also highly recommend reading. The implications of blind risk-taking are highly obvious in both books (Jesse Livermore lost his entire fortune in four separate instances in the first book and the highly talented LTCM team managed to nearly destroy the modern financial system in the second book), and yet, research has shown that many of the most intelligent people on the Enron trading floor were nothing more than compulsive gamblers or too arrogant for their own good. For example, the Enron daily position reports show that Greg Whalley, a former army tank capital and the COO of the wholesale business (whom Jeff Skilling described as one of the smartest people he knows), was down about $30 million in his trading account during 2001 when Enron collapsed (he continued to trade despite occupying an executive position).
Another such figure was the 26-year old trader named John Arnold. In the book "The Smartest Guys in the Room," the authors described John Arnold in this way: "In late 2000, a 26-year-old superstar trader named John Arnold - who was revered for being able to do complex mathematical equations instantly in his head - hit a bad losing streak and went from being up $200 million to being down $200 million in the space of less than a month. On Wall Street, such a performance might well have gotten Arnold fired. But when Skilling heard what had happened, Whalley told him that everything was cool. And so Skilling came down to the thirty-second floor, where the traders worked, and put his arm around Arnold in a public show of support.
The ability to quantify risk is not totally dependent on one's IQ - even though there is somewhat of a correlation. In a complex world and in today's information age, it is the ability to simplify each potential investment and filter out all the unimportant information - as well as minimize the number of real-world variables that we need to guard against. Let me illustrate. Suppose one believes that copper prices have now topped out and are in the midst of heading down. One can do several things to take advantage of this "knowledge" - including shorting the shares of companies that produce copper, buying stocks of companies that use copper (such as homebuilders), or shorting the commodity itself on the New York Mercantile Exchange. The speculator who have only dabbled in equities would argue that the first two options are probably the safest options, as they are unfamiliar with the commodity markets as well as uncomfortable with the huge amounts of leveraged involved. This author, however, would argue otherwise.
First of all, there are many other real-world variables with shorting the shares of individual copper-producing companies. There are geopolitical concerns, as well as concerns about certain individual mines and about company management. For example, what if the company you are shorting suddenly finds a significant amount of copper deposits during the time that you are short the company? Moreover, mining companies usually produce other commodities besides copper. For example, Phelps Dodge has done very well over the last few years most probably because of the rise in molybdenum prices - not copper prices. Freeport-McMoRan, meanwhile, has also take advantage of rising gold prices as well as copper prices. Sure, one can lessen the impact of these other variables by shorting a basket of copper-mining stocks, but this does not diminish the fact that other commodities and real-world variables also have a bearing. To ensure a "pure" play on copper and to minimize the real-world risks, one should directly short the copper contract on the NYMEX - and not the shares of copper-mining companies. Until a company has developed an ETF for the commodity, then speculating via a futures contract is still the safest and most logical way to go.
Another way to minimize the number of variables in a potential investment is to gather as much information as possible on each of your potential investment. Of course, this is based on the beliefs that the market is not totally efficient - as this author has always believed. In this case, diversification of buying the S&P 500 blindly is not sound advice - just ask anyone who bought during March 2000. On the other hand, if one has done his or her research, then holding four or five stocks in one's portfolio is most probably enough, as long as one can stand the volatility and have a sound exit strategy (Warren Buffett's partner, Charlie Munger, as previously stated that holding three stocks is enough if one can withstand the volatility). Anything over five stocks is probably overkill (there would not be enough time to keep track of all your investments and to think of new ones) for the typical retail investor.
I will now illustrate with an example. During the Franco-Prussia War from 1870 to 1871, Junius Morgan (the father of John Pierpont Morgan) rose to prominence by leading the financing for the French Government. Quoting from "The House of Morgan":
Junius's big chance for a state financing came in 1870, when the Prussians crushed French troops at Sedan in September, seized the emperor, Napoleon III, and laid siege to Paris. After a republic was proclaimed, French officials retreated to Tours and set up a provisional government. Otto von Bismarck, the Prussian chancellor, tried to isolate the French diplomatically. When they approached London for financing, he conducted a propaganda campaign, blustering that a victorious Germany would make France repudiate its debt.
Barings had already floated bonds for the Prussians, and the Rothschilds dismissed the French cause as "hopeless." Moreover, Mexico and Venezuela had recently defaulted on their debts, and no-one in London was in a mood to be venturesome at this point. The Morgan-led syndicate floated an issue of 10 million pounds (the equivalent of US$50 million at that point) at 85, or 15 points below par. Quoting from "The House of Morgan":
This sharp discount was designed to coax a skittish public into buying. The French felt blackmailed by these degrading terms, which they thought suitable for a Peru or Turkey. Yet Junius hadn't exaggerated the risks. After Paris fell in January 1871, followed by the Paris Commune, the bonds dropped from 80 to 55, and Junius desperately bought them to prop up the price, nearly wiping himself out. This was all very strange for a man who had urged caution on Pierpont: he was betting the future of his firm on one roll of the dice.
And yet, when the war ended, the French Government repaid the loan in full, netting Morgan 1.5 million pounds, or the equivalent of US$7.5 million at that point in time. From then on, Morgan's name would be mentioned with the likes of the Rothschilds and the Barings. No doubt, the venture of buying the bonds to prop up the price was a risky venture, but was Junius Morgan being a total gambler? In this signature deal, Junius Morgan would take a page from the Rothchilds' book - by using a fleet of carrier pigeons to ensure that Morgan would receive the most-up-date and the best information. Some of these pigeons were shot down and consumed by starving Parisians, but some of them actually got through the Channel. Morgan also engaged in extensive research of the history of the French government - stating that in the history of 12 French governments since 1789, "not one of these governments had ever repudiated or questioned the validity of any financial obligation contracted by any other. The continuing financial solidarity of France was unbroken." It would not be the first time that a Morgan - armed with more and better-quality information - has gotten the upper hand of the politicians, and nor will it be the last.
To summarize: Before one makes an investment or speculate, one should do as much research as possible, and since many things can go wrong in this world of ours - one should also minimize the number of real-world variables in the investment equation. Time is also a factor. The more long-term the investment horizon is, the riskier the investment. That is why having an exit strategy is as important (if not more important) than having a good "entry strategy." Finally, risks, in general, are not easily quantifiable - especially when it comes to investing in equities or in betting on certain outcomes. Given the concept of "Modern Portfolio Theory," the typical professor would have labeled Junius Morgan as a pure gambler, and the retail investor who bought the S&P 500 in March 2000 as an investor. This is the main reason why Long-Term Capital Management mainly focused on bond convergent trades in developed countries when it first began business - and it did a spectacular job at that as well, until the hedge fund started operating in the emerging markets and the equity markets as well. The valuation of a bond is more objective, as it is basically the net present value of its future payments - which is strictly defined, and further discounted by some sort of credit risk. With equities, however, anything goes (the valuation can be justified by many models). It also did not help that LTCM also engaged in directional trades towards the end of its life as well. The lesson of LTCM is that despite the many advances we have witnessed in the field of finance, risks are still not easily quantifiable - and hopefully, this author has argued a good case of my own concept and perception of risk - as well as how we could take advantage of them from an investment standpoint. The steps that I have illustrated have worked throughout financial history, and they will continue to work unless some person or hedge fund successfully develops a supercomputer which has the ability to model every economic decision made by every single person in this world - essentially an impossibility (see "reflexivity" and "chaos theory").