Humility and The Pain Trade
If you don’t bring a humble attitude to the markets, the markets will quickly humble you.
Being humble is fundamental to everything we do at Robot Wealth: in our own trading, and in collaborative research in our Bootcamps.
The more we trade, the more we are humbled by the markets.
The more we are humbled by the markets, the simpler our trading becomes.
The financial markets are very efficient. Good traders inherently understand this, because good traders know it is hard to make money trading. Understanding this point is a critical starting point for a trader’s success.
At Robot Wealth, we call this Embracing the Mayhem.
You must understand the efficiency and the randomness in the market, and you must accept it.
Embracing the Mayhem is the first step.
Next, you must understand the games available to you as a trader. You must pick the ones with the best chance of a positive outcome, and you must play those games in an effective way.
There are two types of games available which will pay you:
- Collecting Risk Premia
- Exploiting Market Inefficiencies.
You get rewarded over the long term for taking on certain risks that others find unattractive (risk premia), or you get rewarded for exploiting fleeting inefficiencies in the market (alphas.)
The first is uncomfortable.
The second is hard. Alphas come and go. The market is extremely efficient.
Relying on alpha generation to provide all your trading returns is an overconfident bet.
We believe that:
Every trader should structure their portfolio so that they are likely to make money even when their alpha signals or active views are wrong.
Embracing the Mayhem of the markets leads us to Being Humble.
We should be paranoid about losing our active edges. It is sensible to be worried about this. It’s a hard game to play, and it makes perfect sense to structure things so that we can make money even if we lose our alpha.
Harvesting Risk Premia
One of the best and simplest ways to do this is to maintain a constant allocation to long-term risk premia.
Being uncomfortable is better than going broke.
The main performance drivers of this strategy are:
- Asset Selection – picking positive carry assets with exposures to diverse global risk premium which have been historically well rewarded
- Risk Management – minimising unrewarded risk through diversification and volatility management.
The strategy is a simple, but sophisticated, risk parity portfolio with some very subtle active tilts.
It is a humble portfolio. It makes little attempt to predict the premium we receive for certain risks at certain times.
We know we’re paid over the long run for taking exposures to certain short term risks. So we look to have exposure to as many of these as we can, and to equalise our risk across them.
Short term pain is the price we pay for long term gain. If we try to sidestep the risk, we are likely to sidestep the premium too.
Interest Rate Risk – A Case Study
US Treasury Bonds are a wonderful asset class. They’re a positive carry asset with long term negative correlation to global risk. They are exposed to the risk of real interest rates and inflation increasing.
One of the (self-imposed) constraints on our risk premia portfolio was that we want to trade ETFs only. US Treasury Bond ETFs are less volatile than the other ETFs in the portfolio, so our risk parity sizing algorithm assigned a significant share of the total dollar exposure of the portfolio to them.
This alarmed many of our Bootcamp participants.
As we were putting the finishing touches to the strategy in November 2018, the following was a common concern:
“I’m concerned about the dollar weight of fixed income in our portfolio. The 30-year bond bull market is coming to an end. Bonds are trading at a premium. Rates are likely to go up. We are buying expensive bonds that are likely to tank. Bond’s risk/reward isn’t good at all.”
^ Paraphrased from real participant comments.
Embracing the Mayhem starts with understanding that nothing is ever that clear cut.
Maybe you think you have unique, valuable insight into the economic and monetary system? Maybe you think you can use this to predict future bond prices?
You probably don’t. And you probably can’t.
And neither can I, Warren Buffett, Jimmy Buffett, Ray Dalio, or anyone else.
But don’t worry about that, we don’t need to play those prediction games to make money. We can play different games.
So what’s the humble thing to do here?
The humble thing is to understand that the current market price is as good an estimate of fair value as you’re likely to come up with, without access to privileged information.
The humble thing is to understand that the risk you are trying to sidestep is exactly the risk we are being rewarded for by holding the assets. Taking on that risk is the whole trade!
Holding interest rate risk gets rewarded over the long run because people are worried that rates are going up, and that their bonds are going to look comparatively expensive.
Taking on interest rate risk in the face of this concern is the trade that gets rewarded here.
Trying to sidestep the risk when it looks the riskiest is…. not.
If we try to sidestep the risk, we also sidestep the premium.
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How Has it Played Out?
We received those comments at the beginning of November 2018. US Treasuries had been in a mini bear market since 2016 and it was becoming a consensus view that the risk/reward of US Treasuries was not looking good.
6 months later and TLT is up over 12%.
We didn’t include TLT in our risk premia collection strategy because we had some kind of grand insight on rates, or any other special ability to predict the future.
We included it because:
- it is a positive carry asset
- it is exposed to interest rate and inflation risk
- it has excellent diversification properties in a portfolio of global risk assets.
We included it because being long TLT gives us plenty of room to be wrong and still make money.
Don’t try to be a hero. Be humble, at least in the way you approach the markets.
Give yourself plenty of room to be wrong and still make money.
Disclaimer: None of this is investment advice. The author is long a “sh-t ton” of US Treasuries across the curve.
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