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The Big Misinterpretation

January 09, 2020

When it comes to finance, there can be a plethora of misunderstandings coming from seemingly experienced investors who pursue steady, linear, benchmark exceeding returns - but ultimately end up chasing the latest trend. They run from investment to investment, selling low and buying high, from stocks to bonds to commodities, all in the hopes that they’ll be able to grasp the ever fleeting outperformer. Here at National Securities, (my partner) Bill Morrison and I, thoroughly communicate to our clients our perspectives on many topics, with the intention that they can become more aligned with the essence of financial instruments. With over 34 years of experience, we can affirm much of Benoit Mandelbrot’s The Misbehavior of Markets, and Nassim Taleb’s Anti-Fragile, and it has become clear to us that there are a few concepts that should be clarified in order for investors to grasp a deeper understanding of how to potentially outperform the market over time. Some of the topics we’d like to discuss here revolve around: volatility vs systemic risk, the roughness of financial markets, and anti-fragility.

“Roughness is no mere imperfection from some ideal – it is the very essence of economic objects.” This quote by Benoit Mandelbrot is a concept that we thoroughly embrace on our team. We have spent considerable time researching and experiencing the true nature of financial markets and we have found a few things of note:

1) Markets are rough, turbulent, and vastly unpredictable
2) People have expectations and emotions which are counterintuitive to financial instruments
3) These conflicting qualities create friction, and embed systematic risk over time

While it may sound indecorous, the crash of 2008 was not by accident. Some might say it was “financially engineered”. Essentially, humans are creatures that crave predictability, and they long for gratification. The typical investor wants to see his investment increasing in value, day over day, year over year, by a set percentage, without fail. This is not how financial instruments function – they run on their own time structure, they’re streaky, have erratic personalities, and are untameably rough. This dichotomy of natural characteristics creates friction between investor and investment, and as humans’ work harder to domesticate these instruments to fit our tolerance (or intolerance rather), this continues to imbed and compound risks in the system, waiting for enough turbulence to trigger a collapse. In other words, the more the regulators try to manage the economy and market participants create new instruments to control the market, the bigger the fallout when true risk is realized.

Now we come back to volatility, and its misinterpretation. Many people believe that low-volatility investments are “low risk,” without understanding that there is (without question) an undiversifiable risk that is embedded into every investment. This risk is called systematic risk. The MBA’s in class right now learning about Bell Curve and Modern Portfolio Theory will not be exposed to the genuine significance of this idea because market crashes and pops are “outliers” and “improbable”. But here at National, we understand that these crashes and spikes can generate or erase an entire years’ worth of returns in a single day – and they’re considerably more regular than most investors are led to believe. So while most investors will write off outliers and shepherd the herd towards modern portfolio theory - we continue to use our ideas to build portfolios which can defend, or even benefit from these outliers and improbable events. That’s the concept of anti-fragility, and it’s one of the most important concepts in our investment philosophy. If you’d like to learn more, let’s share a conversation and put our minds together.