Uncertainty and Irrationality

Investment models that account for uncertainty, volatility, and failure succeed in the long term.

Events in Ukraine, oil and natural gas markets, commodities, supply chain disruption, and spiking inflation highlight that, while none of these were predictable, all represent increasing uncertainty permeating all markets. The pandemic and war in Ukraine were unforeseen, but that’s just the point, unforeseen events will occur. It is a waste of time to try to predict the specifics, it is an essential investment strategy to manage risk to not only withstand but profit from “certain uncertainty.”

Irrationality, not only in human behavior (with unfortunate, often tragic results) but market movements, investment volatility, and bewildering prices, is another certainty. “Mr. Market” as Benjamin Graham said, “is an irrational schizophrenic.” Investing as if he is not assures an investment strategy that will ultimately fail.

Speaking of Failure

An increasing number of growth and momentum investment funds are shutting down after sustaining significant losses recently, a sign of the severe pain the selloff in growth stocks is inflicting. More importantly, it signals an inability for investment funds to manage risk and understand that markets and investments do not move in a singular direction for long, and the correction is sudden and painful – regardless of how compelling “momentum” may seem.

Risk management is the key to investment sustainability, but this seems to go ignored among most investment professionals. Frequent and extreme volatility is here to stay, and that is likely to decimate growth and momentum funds, as well as highly leveraged equity investment funds (from LTCM in 1998 to Archegos in 2021, the lesson is never learned for long – and there will be more examples to come).

Clear and coherent markets, free from political agenda, bad compromises, and ineffective regulation are almost nonexistent. The consequences continue to be pyrotechnic.

The Same Movie. The Same Ending.

“Years ago, I noticed one thing about economics, and that is that economists didn’t get anything right.” – Nassim Nicholas Taleb

Nassim Taleb’s wisdom is even more applicable for most hedge funds and investment managers. Specific “Black Swans” cannot be predicted, but what is almost certain is they will occur. Ignoring this is bewildering, imagining one can outwit a Black Swan is absurd. It is watching the same movie and expecting a different outcome – the investment world’s version of insanity.

Over-leveraging growth investments, piling into overhyped ” flavor of the month” transformational companies (shall we mention the ARKK ETF – allegedly managed to diversify risk and disproportionately profit from ” valuable innovation and growth” – is down over 50% six months?), and social media memes may produce near-term attractive, even spectacular results. But these all end badly, sometimes slowly, but ultimately, and usually quickly.

Debating Gravity

The typical story these investment funds attach to their portfolio is that these investments represent companies that reliably post above-average growth. They forget to mention a time horizon because, as Daniel Kahneman repeats over and over again, one cannot avoid “reversion to the mean.” In other words, nothing grows “above average” forever, and the timeline is usually much shorter than you think.

Leveraging investments assuming there will be sustainable above-average growth and superior returns have been disproven so many times it’s as if we have to debate gravity.

The “growth trade,” generated huge profits, but it is unraveling. Low-interest rates and less attractive alternatives fueled demand for companies expected to deliver faster-than-average profit growth. Higher interest rates, global uncertainty, recession, and the reality that very few companies can deliver superior growth over any meaningful timeframe make an investment strategy that ignores these factors naïve. Additionally, assuming that there are dozens of these companies that can sustain superior growth defies reality and is foolish.

These firms blow up. Ignoring the inevitable – volatility and reversion to the mean  – makes it not very challenging to predict.

Here we Go Again

“Structural shifts” in the market are the typical reason given for these blowups. But there is nothing structural about these strategies. It is simply chasing the “flavor of the month,” and that never ends well.

It is not as if the world hadn’t provided ample warnings about the risks associated with irresponsible finance. History has centuries worth of such examples, but even looking at recent events over the last 25 years is illuminating.

In 1996, driven mostly by Silicon Valley tech stocks, Alan Greenspan acknowledged the “irrational exuberance” of the markets (as if this were a one-time occurrence), but stock market valuations continued to rise.

The warning signs of uncertain growth and unstable economies were believed to be localized and the broader markets decoupled from this turbulence. This was naïve thinking then and outright irresponsible now.

Highly Leveraged Bets with No Downside, Right?

Long-term Capital Management (LTCM) is an illustrative, even if extreme, the example of short-term spectacular success combined with inadequate risk management feeding a belief that one can “beat the market” on a long-term basis. Using extreme leverage and assuming there is a singular price direction generates superior and sustainable returns. Until it doesn’t.

LTCM leveraged drastically to amplify its returns. This worked so long as markets behave rationally and prices didn’t swing well outside the norms dictated by probability metrics. Except markets do not behave rationally, and prices will swing well past normal distributions. Oops.

This Time It’s Different

No, it’s not.

Blinded by genius and short-term performance, (sound familiar?) the hedge fund seemed to be the vanguard of a fundamental change in investment strategy – and it was earning incredible returns. In both 1995 and 1996, the fund earned 40%, outperforming even the roaring stock market.

By 1998, LTCM had $4.8 billion in equity and more than $120 billion in debt, exposing the extraordinary risk of catastrophic industry-wide failure. It was sudden and almost incomprehensible. The geniuses somehow missed predicting the future accurately.

But all investments’ value is determined by future events. Mathematical models imply precision but are based on an analysis of current events and are rarely accurate in predicting the future. Similarly, today, we have seen investment managers raise enormous amounts of capital based on events of the recent past, but the future has a way of misbehaving. Markets do not behave rationally because investors are irrational. Eventually, the “irrationality bomb” goes off and most assumptions are useless or worse.

The normal distribution of prices works most of the time, but not all of the time. That’s when disaster strikes. It is these very swings outside normal distribution – a “Black Swan event” – which is an eventuality in every market. Strategies that work under normal conditions will ultimately fail spectacularly.

Of course, this seems obvious today and would be downright stupid to assume. It’s just that at LTCM Nobel Prize winners preached this narrative, and billions of dollars in capital followed. Disaster resulted, and we’re seeing versions of this play out today.

Always beware of experts. The real world is not a predictable math problem.

That’s Not What the Formula Says

Markets are individuals making investment decisions – multiplied by billions. But, despite this scale, a market’s performance cannot escape human behavior – unpredictable and irrational. A rational predictive model cannot be built on a foundation of irrationality, but this practice continues, and it continues to fail.

Leverage magnifies profits, but it also magnifies losses. Magnified losses become terrifying quickly. A lesson learned and relearned is that money is earned slowly and lost quickly. Too much leverage is catastrophic.

Uncertainty is Certain

The idea that markets are uncertain, and consistent prediction is essentially impossible, is not new. John Maynard Keynes published a book on probability and uncertainty in 1921, with this concept of uncertain and irrational markets forming the basis of his general theory of financial markets. So, years before the stock market crash of 1929, and almost every 10 to 15 years afterward, the cycle of financial crashes and panics was predicted by a well-publicized thinker, and then, as is typical, ignored. The lesson is simple, and Keynes laid it out 100 years ago:

“Markets seem rational but only during periods of stability.”

Instability is Here to Stay

Extrapolations from experience, or an attempt to exploit “transformational moments” quickly become meaningless as soon as new or unpredictable factors emerge – and new unpredictable factors always emerge. As we have seen lately, those factors can be almost anything, and it’s likely we didn’t see any of them coming; a market bubble bursting, a war, a pandemic…whatever. It will happen.

Markets are uncertain. A confident investment strategy based on singular predictive models work well for a short time, and perhaps most of the time, and that is their fundamental flaw. They will fail.

Investment models that account for uncertainty, volatility, and failure succeed in the long term.