Week in Review 5/4
by Zach Marsh on May 4, 2018
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S&P 500 -0.26% S&P 500 +0.75%
10 Year US Treasury 0.24% 10 Yr US Treasury -1.26%
Gold -0.76% Gold -0.84%
Volatility -3.18% Volatility -20.2%
Our Weekly Reading: Negative Impacts of Liquidity and Perpetual Pricing
In my former life, I was an options trader on the floor of the Chicago Board Options Exchange. This was a time back when humans roamed the floor. Like the dinosaurs before them, human beings’ presence on the trading floor has all but been wiped from existence. But once upon a time there were people standing around in pits on trading floors, for the sole purpose of matching buyers with sellers. The broker was there to represent the buy or sell order from the outside, investing public, while trader’s role was to provide liquidity for those orders. Viewed by the rest of the world as “traders,” on the floor we were referred to as “market makers”—the providing source of liquidity and pricing. Absent a market maker there would’ve been no realistic bid or offer price for any stock, future, or option. If you wanted to sell 100 shares of a stock you would have had to wait for a natural buyer of that stock to materialize. If that stock was Apple that wouldn’t be much of a problem, but in less liquid stocks it would be problematic. In addition, because there is/was a market maker, holders of a stock, future, or option never had to guess as to what the price was, at any given time, of that asset. Market makers, consequently, were the source of liquidity and valuation on a perpetual basis. Therefore, as a former market maker it pains me to say this, but liquidity and perpetual valuation, while convenient, can be a wolf in sheep’s clothing.
I believe, as a people living in an open and free democratic society, we are taught to value transparency. We believe it is a God-given right to know where we stand at any moment. Knowledge is our birthright. But, in certain areas, these things can lead to many unintended consequences and pray upon our behavioral tendencies, causing us to react poorly and make bad decisions. Investing is one of these areas. Since our investments are priced second by second, and day by day, we can become hyper-sensitive to the shorter-term fluctuations in valuations. As our portfolios grow rapidly we start imagining all the great and wonderful things we will do with that money, and when our portfolios fall we begin to panic and worry that we will soon end up in a breadline sometime in the future. While the extremities of concern and euphoria vary by personality, to some degree we all engage in this thought exercise. Unfortunately, the ability to see up-to-the-minute valuations for our investments only exacerbates our emotional responsive tendencies.
Imagine for a moment coming home to find this, the value of your home and your neighbors’ homes crossing our garage like stock tickers crossing the tape.
Seeing your home value fluctuate real-time would be enough to drive you mad. Coming home after a long day, happy with the day’s events, only to find that some stranger has taken a large short position on your home or all the homes in the neighborhood, your mood would quickly sink from contentment to frustration. The constant, daily re-valuation would eventually affect your mindset from, “I don’t care what the real estate market is doing right now, I’m not planning on moving anytime soon,” to “I wonder if I should get out or keep holding.” The more readily available the valuations of your assets are, and the more liquid they are, the greater the tendency to mentally shorten your time horizon, even though you invested for the long term when you incepted your investment portfolio.
Most investment portfolios take time to approach their long term expected average return. During the shorter term, returns can vary wildly around the long-term average. Below is a comparison of two investment portfolios, the first is a portfolio consisting of 100% S&P 500, the second is a risk parity portfolio with a modest 150% leverage.
These charts illustrate the tendency of both investments to converge over time toward their long-term expected average. The higher risk portfolio (the above 100% stock portfolio) takes a longer time and experiences the potential for even greater near-term variance of returns. During the first 5 years one could witness a range of returns of nearly 35% from high to low. Meanwhile, the lower risk portfolio has a narrower band of performance after 5 years, with only about 17% separating the expected high and low performance.
Long term investment success begins with knowing your time horizon, employing an investment strategy that has shown success over similar time horizons in the past, and sticking with it even when shorter term results can make it difficult. Let’s put it this way, if your time horizon is 3 months you should buy a 3-month T-Bill, however don’t expect that same investment to perform well on an inflation adjusted basis over a 20-year period. Below is the performance of a 100% T-bill portfolio. While everyone would appreciate the greater consistency of returns, few could achieve their financial needs on only 1.3% real long-term returns. Return variance is the trade-off for higher expected returns.