Doubling Down on Risk

In August of 2007, we had one of the first truly large market dislocations that preceded the financial crisis. All at once, a large group of the biggest quantitatively managed hedge funds all started to get crushed at the same time. In just a couple of weeks, strategies that had worked brilliantly for years stopped working and no one really knew why. Many of the funds utilized similar strategies, but they were diversified, so it was odd that they were getting hit from all sides.

No one really knows who patient zero was, but the theory is that this was a large fund that was being hit with redemptions and margin calls from using too much leverage. The best account of this volatile period comes from The Quants by Scott Patterson. Here he discusses one of the largest hedge funds from Goldman Sachs and how they reacted to the increase in volatility:

At the headquarters of Goldman Sachs Asset Management in downtown New York, everyone was on red alert. One of the largest hedge fund managers in the world, with $30 billion in assets, GSAM was getting hit on all sides. It was seeing big losses in value, growth, small-cap stocks, mid-caps, currencies, commodities, everything. Global Alpha, the Global Equity Opportunity fund — every strategy was getting crushed. And like every other quant fund, its captains, Carhart and Iwanowski, had no idea why.

GSAM’s risk models, highly sophisticated measures of volatility, had been spiking for all of July. It was a strange sight, because volatility had been declining for years. And the way GSAM’s models worked, the decline in volatility meant that it had needed to take more risk, use more leverage, to make the same amount of money. Other quant funds had followed a similar course. Now volatility wasn’t behaving anymore. Volatility was actually…volatile.

The majority of these funds ended up capitulating after large losses occurred because they started receiving their own margin calls and the risk models they used couldn’t explain what was going on. Only one or two of these funds were able to take advantage of beaten-down markets but the majority compounded their problems by dialing down risk before the eventual snapback rally.

This doubling down on leverage reminds me of an old friend of mine who thought he had a foolproof system that would never allow him to lose money at blackjack. Each time he lost he simply doubled his bet, with the hopes of always breaking even at the very least. This strategy sounded great in theory until his losses started to compound exponentially and he could no longer stomach going back to the ATM for more cash.

Doubling down your risk is something I think we’ll start to see from investors in the current low-interest rate environment. In a post this week at The Research Puzzle, Tom Brakke highlighted a great quote by John Minahan from a recent CFA roundtable discussion that I couldn’t help but use myself:

Minahan: One of the things that I have learned is that when yields or expected returns are low, investors are inclined to take more risk because they either imagine they have or actually do have some return target they need to meet.

I often think that is imagined, and it leads to investors taking more risk when they do not get paid for it. I think that this “reaching for yield” phenomenon is something that should be avoided. If you are in a low-return environment, accept the low returns. Do not take risks unless you expect to get paid for those risks.

Trying harder in the markets doesn’t usually lead to better results. In fact, more often than not, it leads to worse performance. Markets don’t always cooperate when you try to hit a certain return target either. And reaching for yield because you feel safe by earning a certain level of income on your investments is a great way to take more risk where you probably aren’t looking to take any.

There are a few simple ways to control for a low yield, low returning environment:

  • Diversify broadly across asset classes, investment styles, market caps and geographies.
  • Take advantage of volatility by rebalancing periodically. If volatility does increase there could be more opportunities to take advantage through a simple rebalance.
  • Keep your costs low as they will now eat up a larger percentage of your gains.
  • Save more money.
  • Follow a consistent process and don’t get caught chasing fad investments.

I’ve been talking about the prospect of lower future returns for a while now, but I think it’s an important point of emphasis because setting the correct expectations as an investor is so critical. I have no idea what’s going to happen in the future with regards to market performance, but if the forecasts of lower future returns come to pass (and there’s a good chance that it will), discipline, patience and risk management will matter more than ever.

The Quants
Financial Market History Roundtable, Boston

Further Reading:
Rooting For a Bear Market?
The Hardest Part
Expectations Management

Now for what I’ve been reading this week:

  • Should you invest 100% in cash like Mohamed El Erian? (Prag Cap)
  • Warren Buffett answers questions from a group of MBA students (Ben Graham Investing)
  • How Rolling Stone fell prey to behavior biases in their reporting (Fortune)
  • 11 stock market rules to live by (Midnight Trader)
  • Is there a relationship between the economy and the stock market? (Econompic)
  • Why simple solutions often beat complex ones with your finances (NY Times)
  • Don’t let bias corrupt your analysis (Big Picture)
  • What if you knew exactly what the economic data was before you invested? (Irrelevant Investor)
  • How broker incentives shape financial advice (Alpha Architect)
  • Life after PIMCO for El Erian (OC Register)
  • James Osborne’s 10 year journey to running his own financial advisory business (RIABiz)
  • Louis CK’s epic love letter to NYC (Hollywood Reporter)




What's been said:

Discussions found on the web
  1. Grant commented on Apr 10

    I’d add one more. Or spend less and/or work longer. It’s certainly a mistake to take more risk than you can tolerate just to aim for a particular return.

    • Ben commented on Apr 10

      Good ones. Not fun alternatives for some but much safer.

  2. Jelly commented on Apr 10

    I refuse to believe that you actually know someone that fell for the Gambler’s Fallacy.

    Unless your “old friend” is a cliche down-on-his-luck gambler from a 1940’s flick.

    • Ben commented on Apr 10

      Ha. True story. When I was a senior in high school all of the Indian casinos in Michigan changed their gambling age to 18. We went almost every weekend. I think (hope) we all learned some good lessons. Sadly, this story is true. My friend really did think he had it all figured out. Funny how it usually works out better for the house.

  3. Gray_Williams commented on Apr 10

    Martingale! I did this once at Luxor eons ago in my early 20’s. Took me from $5 min to $5k limit twice in less than two hrs. Got lucky on both $5k hands. The army guys sitting at the table loved the drama, bought me beers. My wife looked on in disgust, realizing she’d married the village idiot. My buddy thought the whole thing was hilarious. (Same guy bet red and won against a string of 13 roulette blacks – while I was at the ATM getting more cash, after busting out from 8 straight rolls against. Good thing he’s fast, or I’d just be getting paroled about now.)

    Was shaking afterwards. My *big* win for the psychological roller coaster? $1230. ($300, minus roulette from the night before.)
    Have been a student of market psychology, probability theory, behavioral economics and cognitive bias for a number of years since.

    This has a number of great comments:

    • Ben commented on Apr 10

      Wow. $5 dollar table all the way to $5K hands? That’s impressive. Best story in a comment I’ve ever received. I can’t believe you were able to pull that off twice. I will say this — it’s very hard to beat the rush you get from playing a really large hand in blackjack. Hopefully you had a few drinks in you. Gotta love those multiple ATM runs at the casino with a $12 fee every single time.

      I have a few other good blackjack stories from over the years. Maybe in a future post. The best casino game IMO by far. Ever read Beat the Dealer by Ed Thorp?

      • Gray_Williams commented on Apr 12

        Thorp is likely one of the primary reasons math & physics majors are in such demand on wall street, and why their computers algorithms run the show:

        (Just finding a $5/$5k table is rare, the probability of winning not one, but two 12th-hands (after getting beat 11 straight) – in a single two-hour sitting – is something in the 4-5 sigma range..and I have $5 on why this answer – ie the current state of probability mathematics – is why we keep seeing events every couple years that the models say shouldn’t occur but every 100 (1,000 – 1,000,000,000) years or so… )

        • Gray_Williams commented on Apr 12

          All this thinking on days long ago has dredged up another memory. Remember the options backdating scandal in 2004? Apple, Triquint, Marvel, Broadcom, etc… you do?

          LoL, me too. I was in a few of them at the time.

          All of them, actually.

          Even better, as each one announced, I would dump the stock and plow whatever I had left into the remaining stocks. And each day, down would go another. And another.

          Not to worry, I was also heavily leveraged.
          And “managing” some of my parents’ money.

          To this day I still marvel, what were the odds? So I rediscovered religion. And probability theory. And I went back to work. Paid back my parents. Built and sold a company. Ultimately, what I learned (again) is risk happens. And this is why God, in his infinite wisdom, rested on the 7th day, but before doing so, created OOM put writers. (And that catastrophic hedges aren’t actually all that expensive in the grand scheme of things.)

          This traumatic story actually turned out ok. My wife is still with me, so I’m guessing she probably is in it for the long haul. It also helps that I was able to invest the proceeds of my company in 2009. And I have been trading for a living ever since. Not a bull, not a bear – just an ardent believer in risk management, investor psychology and volatility.

          • Ben commented on Apr 13

            Thanks man. And thanks for sharing your stories. I’ve found it’s somewhat cathartic to get it out there. It’s crazy how important it is to understand your high school statistics class when thinking about probabilities, but it’s a mindset most people don’t use or understand.

  4. Smart Beta Crash Coming? commented on Mar 20

    […] crashes can occur because certain areas of the markets become too crowded (see the quant crash in 2007 as an example). But crashes are usually consistent with the use of leverage or concentrated positions. Historical […]