Risk Management In A Nonsense World

One of the myriad confounding factors in what's been variously billed as the "Great Inflation Debate" is the difficulty in assessing the veracity of claims centered around the notion that Americans haven't experienced a serious bout of inflation in decades. Almost immediately, that assertion is met with the following protestations: "Oh, really? What about the cost of college tuition?" And then: "Oh, is that right? How about the cost of healthcare?" When we can't even agree on whether Americans

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13 thoughts on “Risk Management In A Nonsense World

  1. I am concluding from all this that nothing we are dealing with is ‘ real ‘ partly because of the fact that the “ship Lollypop ” is sailing in uncharted waters . It wouldn’t be so tough except that everyone is front running the inevitable second shoe to drop so it’s almost always buy the dip time…
    In reality you have to ‘ feel this market ‘ and that becomes an intuitive process probably helped along by simplification of extreme complexities. If there is one thing after years of reading here on H…Report that I cherish the most it is the Reminder to try to ID the narrative and try to stay focused on that as long as you can .. As Kevin M. used to occasionally say ‘I’m not here to tell what could be or should be but what will be ‘. I’ve learned a lot from the exposure here and it has really trashed a lot of outdated ideology in favor of more workable methodology and out looks .. Betting that our moderator usually intends for us to progress in these ways . Can’ wait for Monday sometimes…

  2. There are other ways to deal with risk, if you are only managing your own money and you basically have all spare change in the market.
    Don’t borrow, even at 0% interest; figure out what makes you happiest in life and pursue that (hopefully, it won’t cost a lot of money); live significantly below your means (starting when you are 18); don’t plan to primarily live off of harvested capital gains- unless you are rich enough to live off harvested capital losses; drive your cars into the ground (I had a 21 yr old Landcruiser with 200k miles- which I sold a few yrs ago to my son for the Kelly Blue Book value); fly coach…assuming you fly; have a plan for significantly cutting expenses if your portfolio tanks, long term.
    I don’t need or want hedges beyond those mentioned.
    Having said that, I do not think the Fed, whose members are essentially appointed by our elected leaders will ever cause a reset. We have seen that they have almost no tolerance to causing any pain and “correct” their behavior as soon as any pain is involved.
    And why should they cause or be complicit with a grand reset? It would create anarchy because it is not just the richest of the rich depending on a strong investment climate. Many of the state/local government and private pensions depend on a return at least equal to inflation, too. Even minimum wage workers depend on those further up the income ladder spending money.
    Sometimes you have to go with the flow.

  3. Good article and good commentary. The why question is human nature. I believe the old adage today’s price is tomorrow’s headline is so important. Price movement is real data. Price movement is what helps us get market feel. I think traders realize that price discovery is being suppressed, but the good/bad news is that the market is so big that it can escape the fed or any other outside force. I choose to believe there is no substitute for experience. When I get my ass kicked I label it tuition…..

  4. Gods do not die dramatically, they fade. Everything is always different this time. Inflations of yesteryear were when gold was a God. We have gotten beyond the atom being three simple definable parts You’re writing today leaves much to think about and be discussed.

  5. H

    Very thoughtful. One of your very best.

    My first real estate prof (later my dissertation chair) and I argued constantly about the relationship between value and price. Some argue that (investment) assets have some sort of intrinsic value that markets will find. But in my experience, investing since the 1970s, the market rarely knows or cares about value. It only cares about price. I was taught that prices are determined when an informed buyer and an informed seller agree to exchange an asset and consideration in an open auction which involves other buyers and sellers. Prices set in private exchanges are suspect and not representative of the actual market price (value?) After a time of driving my prof crazy we declared peace and agreed never to speak of such things again. My, I was an annoying little s… in those days. The point is that real people don’t care about the price-value disconnect, only academics do. Besides, the greater fool theory is real. I only need to find one of those fools on a good day to come out all right.

    Mid-way in my academic career someone told me that Cornell University had a policy that offered profs and senior administrators a unique opportunity when they were ready to retire. Reportedly, these folks were given a year leave, with pay, to write the book or do the research they never had time to undertake during their careers. I fantasied about such a perk. My bogey was to write a book about all the different concepts of value accepted and used throughout the world. I wanted to see how these various conceptions might coincide. Never got to that one. I did get to do others but none was as satisfying as I imagined that one would have been.

    As I moved into the realm of the technically rich, as you called it in a few weeks ago, I realized that even as my portfolio grew, I really couldn’t afford to hedge it properly because the expected cost of the most likely tail risks is lower than the actual cost of the hedge. So I hedge the old-fashioned way, putting a third of my money in stable IG fixed income funds, where I earn about 2.5% in current yield. With the rest I diversify further and for the last decade, year in year out, I have stayed on the lower part of the efficient frontier, balancing risk and return, with a stable beta of 0.5x. I’m in the latter half of my 70s and I, too, have been tapped on the shoulder by that guy in the cowl with the scythe, three times actually, and managed to avoid the final judgment. I have more money than I can spend, a high probability of a shorter life span than either of my parents or grandparents, and my daughter regularly exercises the luxury of scoffing at her legacy. So I give away as much as I can deduct to feed the poor and support the education of those who wish to acquire it.

    I’ve had two mortgages costing over 8.5% and I made it through our last bout with real inflation. On one job I had in that time frame I was in charge of filing my company’s reports required by Nixon’s price controls. My own father asked me to cheat on these reports because all our competitors did. I wouldn’t, Leavenworth scared me more than my father. But that lovely inflation also set up a 35+ year golden age of fixed income which, for me, was better than any stock market I saw. For decades buying USTs on the margin was tantamount to stealing. I still get interest from a sweet pile of 7% treasuries. Maybe you can see why I picked the handle I did. Oh and I did get the chance to live with the same woman for 54 years, as my best friend, partner, co-author, and colleague. Pure luck.

  6. Yes, a great piece. It seems markets always take and idea to do it to excess. In today’s world, the upside is privatized and the downside is socialized because central banks are so keen to prevent the downside from materializing perhaps logically because of the link between tighter financial conditions and the real economy. The fear is that the missing piece here is elevated fragility which at some point will lead of a chaotic mean reversion that few are positioned for and possibly something that central banks usual ability to cut off the left tail for some strange reason does not work in the future as it as in the past.

  7. When I think of risk management the challenge I think is to pry apart the physical economic layer where steel is welded, silicon crystallized and lithium mined vs the economic world where proxies and proxy proxies of proxies are traded like baseball cards at a school cafeteria.

    Risk management for the layer where you are trying to produce a physical result is complicated hard work which largely today is done for the sake of the proxy layer. After all if a bunch of hedge funds own a company and financial conditions are such that regardless of actual physical deliverables share prices rise… then mission accomplished. When we start to treat the financial layer as the piece that is important… then you get the world you would expect and which we occupy. Tail risks are generally not the sort of things that affect technocrats, financial elites or oligarchs as they sure are not about to starve or be homeless because a number went down. Actual outcomes are the problem of the general population. The financial layer has foregone any sort of narrative that it actually does something useful by natural principles and laws and instead has begun simply asserting itself as the means to an end it always was.

  8. H- I think the monthly rate for a subscription to your writing is one of the better deals out there, plus I get everyone’s commentary for free! Thank you all!

  9. Benny Hill joke. The chances of someone bringing a bomb on a plane is one in a million. The chances of two people bringing a bomb on a plane is one in 1,000,000,000,000. So if you want to feel safe on a plane, bring a bomb.

  10. Great piece!

    @Vlad Is Mad: Thanks for bringing “fragility” to the discussion. I take that to describe a setup (or the potential for) cascade effects. I understand leverage to be a multiplier of fragility.

    If margin debt is a reasonable measure of leverage, fragility in financial markets is far greater than ever before. Margin debt (as of July 2021) is up 400% (in current USD) since 1997 while the S&P is up ~225%.

    Indeed, total margin debt today is far beyond previous records but in terms of leverage, margin debt pales in comparison to the cumulative leverage in the form of derivatives. The implosion of Archegos Capital Mgmt illustrates the cascade effect magnified by the leverage of derivative holdings.

    Even if the so-called “mean” (to which reversion is said to return) is blurred, the principle still holds. It’s just lost its usefulness as a trading concept.

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