(With Frank Jones, San Jose State University)
Summer seems to have arrived early in California, and with it warm temperatures and, given our El Nino year this year, lots of tall grass, and….rattlesnakes!
As a long-time trail runner, I am prepared for the occasional hazard of the trail (I have never seen a mountain lion in the wild, but know the long term statistics of fatalities from mountain lion attacks), and one of the scariest hazards are rattlesnakes. Last week, I almost stepped on one (for the second time in my life), as it warned me with its rattle and the “I am ready to attack” coil.
Ever since my close encounter with that rattlesnake, my level of fear has increased on each run, perhaps irrationally. Every bent stick in the trail now looks like a rattler, and I intuitively jumped off the trail yesterday when I saw a rope. I slow my gait down at the bend in the trail where I saw it, my adrenalin shoots up, and my attention and awareness heighten. I have never seen a rattler in the same place but I know each place where I have seen one is still very fresh in my mind. Statistically the chance of seeing a rattler in the same place is almost close to zero…but try convincing my primordial survival mechanism of that statistical truth! Memory recall is proportional to repetition and also to the intensity of the experience felt.
In a recent paper by Nobel prize-winning economist Robert Shiller and his colleagues, they document a similar occurrence in the markets. Based on survey data that Shiller has collected for the last 25 years, they demonstrate that investors overstate the likelihood of a crash akin to the 1929 or 1987 crash many times higher than the historical realized probability of such a crash happening.
More importantly, the impact of recent events, and even news, can skew this overestimation. Even more interestingly, if a person is living in a zip-code where there is a large earthquake, they are likely to overestimate the probability of the crash even more, hence correlating events that at first blush have nothing to do with each other.
So the availability of recent data that somehow primes the system to be more “crash-aware” is likely to create a larger subjective probability of crashes. In the language of option markets, such crash phobia can cause a large rise in the “implied volatilities” and “skew” of options on which market pricing is based.
As we have observed before, it is impossible, however, to say with 100% certainty whether this phobia is actually so wrong that a rational, fearless investor could make riskless profits from it. Sometimes, as I very well know, the rattlers really are there; and sometimes as my poor dog found out, they actually do bite! And dry, hot days increase the likelihood of them being out on the trail.
The fact that volatility itself is volatile (the technical word for this is “stochastic volatility” or “vol of vol” in trader’s parlance), can create interesting opportunities for investors who can manage their exposure to volatility dynamically and in a diversified manner. In simplest terms, this means creating a portfolio that is balanced between “mean-reversion” and “trend”, or between assets that provide insurance (such as treasury bonds, and assets that provide investment value, such as equities).
In Chinese philosophy, Yin and Yang (dark and bright) describes how opposite or contrary forces are actually complementary and interdependent. This “duality” — like fire and water, action and reaction, cold and hot, hard and soft etc. — also describes simple truths about investment techniques that have had a long history as “styles”. Investors are tempted to pick one of the two sides of the same coin, but by doing so they might literally be “leaving money on the table”. Investment styles do not have to be black and white, but some shade of grey that results from an optimal, dynamic mix of the dual alternatives.
There are option sellers and option buyers. There are momentum traders and mean-reversion traders. There are top-down (macro) investors and bottom-up (“arbitrage”) investors, and there are directional investment styles and relative value investment styles.
Depending on what has worked in the recent past, or based on our own conditioning from experience or readily available data, we are tempted by heuristics to make quick decisions that might expose rigid biases. For instance, we might take either a stance that things will mean-revert, i.e. what has worked will not work in the future. Or the opposite stance: what has worked, will continue to work. Alas, many an investor has found that forecasting the future phase of markets is almost as impossible as forecasting the weather a few weeks out.
What the dual nature of markets shows us is that for robust portfolio construction, we need a mix of each style so we can benefit from style diversification. The diversification emerges because the time scales and driving forces between the two sides of each duality emerge from different types of investment decisions. The “frequency” or time-scale at which investment styles work is equally as important as the skill of the investor.
The best investors are those who have realized the coherence between their own frequency of active decision making and the natural frequency of the markets they invest in. In other words, the “resonance” between investment style and active decision making is as critical as forecasting expertise. Its for this reason that in the same market, value and momentum can coexist, as can trend and carry, or short and long volatility, or macro and arbitrage.
The trick is not to fixate on any one style or approach, but to practice flexibility and reduce frictions and institutional impediments to taking the approach that is most likely to work.
Archimedes is quoted as saying: “Give me a place to stand and with a lever I will move the whole world”. Of course if one does the computation, the length of said lever would be about 10 to the 23rd power in meters. So this is a theoretical exercise at best. Similarly, the only thing I need to know to be profitable year after year is to know if the market will trend or mean-revert, but this question is also almost completely theoretical.
By combining the dualities of investment styles that emerge from ever-changing fear and greed, and careful risk management and capital control that matches the natural rhythms of the markets, we can hope to do better than picking just one approach. And yes, some of this requires that we look beyond our immediate experience and the mental grooves created by intense market or real-life experiences.
And while risk markets might have erred on the side of too much fear in the first quarter (which set up an almost perfect scenario for a massive rally), we need to be aware that not much fundamentally has changed. As we flirt with all-time highs on the equity indices, any sharp or sustained selloff could quickly bring fear and memories of that selloff back into investors’ minds.
Not unlike the fear of that rattler that I still watch for on my trail runs.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, an SEC registered investment adviser and a CFTC registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.