The 10th Man

Nobody Knows Anything About Anything

June 30, 2016

I don’t want to spend too much time on Brexit, since people have been force-fed nonsense commentary about it for the last week.

I will own up to being wrong about it—I very forcefully said in The Daily Dirtnap that Great Britain would vote to remain, amidst a groundswell of sympathy from the Jo Cox murder, which turned out not to be the case.

Anyway, a lot of folks are making claims about what Brexit means for financial markets, but the reality is that there are so many possible permutations, nobody knows what the hell they are talking about.

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Will or won’t the UK go into recession? Will or won’t other countries secede from the EU (and maybe the euro)? Nobody knows the answers to these questions. We can speculate, but it’s too hard, and I think any forecast is really just a guess here.

Markets don’t like uncertainty, so the one thing for sure is that we are going to live in a regime of elevated volatility for a while.

I will say that long-term, Brexit is very positive for Great Britain (and very negative for everyone else). Free of all the stupid EU regulations, it’s going to be a destination for investment capital (remember, capital goes to where it is treated best).

This is an extension of the state income tax stuff we talked about a couple of weeks ago. Pretend the UK is Pennsylvania and Europe is Maryland, and invest accordingly.

Problem is, it’s hard to invest when volatility is this high, so you can either wait until things calm down, or you can work into positions over a long period of time. Unfortunately, if you wait until things calm down, it’s usually too late.

Here’s what I really wanted to discuss today…

Building a Crash-Resistant Portfolio

I have some experience in this. My investments always underperform in bull markets but outperform in bear markets. For sure, the Street Freak model portfolio is hanging in there, because of its exposure to a couple of stocks/sectors that zig when the market zags.

Most people don’t manage money like this. First of all, if you underperform during bull markets, you’re going to get fired, and if you outperform during bear markets but still lose money, you’re going to get fired. It makes more sense for people to crank up the beta and feast on the returns during good times and then ¯\_(ツ)_/¯ during bad times. Bear market, dude! How was I supposed to know?

One of the reasons you want to build an all-weather portfolio is so you don’t barf it during bear markets. You are a human being susceptible to the shortcomings of your very fragile human psychology, and even if you think your portfolio is the best in the world, if you upchuck it during a bear market, it isn’t much good to you.

So you don’t want to build a portfolio that could take you to the point of maximum psychological pain where you throw in the towel (and the returns stop compounding).

Of course, this is what people pay for when they get professional money management. It’s possible to go through Brexit and only be down 30 bps. They’re called hedge funds. Index funds are doing significantly worse. Sure, some hedge funds are doing badly too, but you will be better off with most hedge funds during a bear market. They can, after all, at a very minimum, go to cash.

That doesn’t mean you have go to around shorting a bunch of things or buying put options. If you buy out-of-favor stuff (like mining six months ago), it is likely to go back in favor when things get rough. Of course, you wouldn’t want to construct a portfolio that is full of out-of-favor things, because then you likely have a portfolio full of value traps.

There is a lot of academic literature on portfolio construction. I took a class in it in business school—while my classmates were building portfolios stuffed with Internet stocks, I had supermarket stocks and gold miners like the old Placer Dome. Level 3 of the CFA is all about portfolio theory, too. But I think it’s a bit more art than science.

There should be two goals to portfolio construction:

  1. You generate alpha
  2. You don’t get sconed in a black swan event when correlations go to 1.

It helps to own tail risk, but tail risk can be expensive, and like I said earlier, you can build a fire-resistant portfolio without paying a lot of option premium. Those VIX calls can get expensive after a while. I have never understood tail risk funds, anyway. To the extent they think they can make money (and earn fees), they must necessarily believe that tails are perpetually underpriced. I’m not so sure that’s the case.

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As for Brexit, GBP vol was high, but not high enough! Tough to get insurance against a 12% move in a G10 currency. Not just a G10 currency, but the former global reserve currency.

If you’re the type of person who ordinarily doesn’t check their portfolio, and you checked it this week, you lose. If you’re the type who does check it, and you didn’t check it this week, you lose.

If you never check it, and you still didn’t check it this week, you win.

All the Evil of This World—in Paperback

I was off last week, so I didn’t get to comment on the book launch. ATEOTW is doing great—loads of positive feedback, and the Amazon page is filling up with reviews. Better yet, you can now get your paperback copy here, which went on sale last week.

Here are a few select quotes from the reviews:

“A literary tour-de-force…deeply illuminating about human nature and the purest distillation of the struggle for money.”

“Leaves you numb. Buzzing. Like a kid who just got off a crazy new thrill ride at the fair.”

“…should be required reading for anyone who is thinking about entering the sales and trading industry.”

“This is the first novel I have read about finance that is a true portrait of the humanity, the pain and the suffering and the triumphs and the sheer weirdness of what it's like to work in the industry.”

Another quote:

“Warning: the book is graphic and rough, these are not people in suits sipping green tea around a conference table.”

I really hope you enjoy it.

Jared Dillian
Jared Dillian


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