John Kenneth Galbraith, in A Short History of Financial Euphoria, condensed a speculative mania into three parts.
- New innovation. Something new, financial or technological, captures people’s attention. It’s not new innovation alone. It’s that, gradually, more and more money concentrates into the assets behind that new thing.
- Debt. The returns on those assets are so good that people want to accelerate their wealth. They turn to leverage, margin loans, derivatives, anything that could enhance returns further.
- The Crash. Liquidity dries up. Asset prices freefall. Margin calls are made. Forced selling occurs. The new innovation assets are scrutinized too late for many. Painful losses are widespread.
Galbraith’s speculative mania also describes how investors blow up their portfolio. A paper titled, How to Lose Money in Derivatives, studied previous hedge fund blow ups and backs that up.
The recipe for hedge fund disaster almost always has three parts: A trader:
- overbets relative to one’s capital and the volatility of the trading instruments used;
- is not diversified in all scenarios that could occur; and
- a negative scenario occurs that is plausible ex post and likely ex ante although the negative outcome may have never occurred before in the particular markets the fund is trading.
One might expect that these two interrelated risk factors (1) and (2) would be part of the risk control assessment of hedge funds. These risks become more pronounced as the total amount trading grows — especially when trading billions.
Some of the biggest hedge fund blow ups in history follow the same pattern. Situational Awareness, Archegos, Three Arrows, MF Global, JWM Partners, Carlyle, Focus Capital, Peloton Partners, Matador Fund, too many subprime players to name, Amaranth, MotherRock, Aman, LTCM, Niederhoffer Investments, Orange County (Robert Citron), Hunt Brothers, and many more in between.
The common theme: too much leverage (overbetting), too much money in too few things (concentration), and an extreme event, seen as almost impossible, exposes the risk (negative scenario).
Also, overconfidence. Overconfident in yourself. Overconfident in the strategy. Overconfident that the market environment driving returns will continue uninterrupted. Nobody takes that much risk without believing that their strategy is impervious to bad things happening or worse…riskless.
How can investors avoid the same fate?
Diversify. A concentrated portfolio may lead to better returns, but it also introduces more volatility than you get with a diversified approach. By more volatility, I mean deeper drawdowns. Can you handle deeper drawdowns? The psychological component to diversification is more important than most realize. It solves the “sleep well at night” problem.
Eschew Leverage. Margin loans, futures, or any other forms of leverage that allow you to oversize positions is best avoided. The upside always looks wonderful. The downside is catastrophic.
Embrace Surprises. The proverbial hundred-year flood seems to happen in markets dozens of times a century. In addition, these extreme events don’t happen exactly like those in the past. All the data and back testing won’t help when extreme outliers hit markets. The best you can do is build a portfolio to withstand worst case scenarios without giving up too much return in the process. Then be ready, mentally, for the inevitable.
Extra Reserves. That means cash on hand. The point of cash is to avoid forced selling at the worst possible moment. For hedge funds, that means holding a part of the portfolio in reserves to cover margin calls, redemptions, or the like. For average investors it means the about same. Having money in reserve, be it a cash allocation or simply an emergency fund, prevents forced selling or raiding your portfolio when money gets tight.
Stay Humble. For investing, a little confidence is necessary to put your money at risk, too much can blind you of the risks. That’s were humility comes in. It keeps you grounded as an investor. Our strategies are not perfect. We don’t know what the future holds. Humility is a remember that we don’t have everything figured out.
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