Weekly Recap 7/13/2018: What Lies Beneath

Weekly Recap 7/13/2018: What Lies Beneath

by Zach Marsh on Jul 18, 2018

Weekly Update

S&P 500   1.53%

10 Year US Treasury  +0.00%

Gold    -1.06%

Volatility  -8.15%

 

 

 

 

Assessing Investment Risk 101:  Find the Danger that Lies Beneath

 

Dylan said it best, “The executioner’s face is always well-hidden.”  I frequently think about that line from A Hard Rain’s Gonna Fall as I am trying to determine the risks of various investments.  I’m pretty sure that’s what Dylan had in mind. 

It seems more than ever investments are structured and pitched with the promise of steady and consistent returns with low historical variance.  They don’t promise to make you rich, they just promise to give you moderate returns above the risk-free rate.  Gone are the days of the ‘80’s and ‘90’s when everyone wanted the hottest investment with the greatest opportunity to make a killing, maybe 2008 put a nail in that coffin for the time being. 

But so called, can’t lose investment propositions have been around since the beginning of time.  Most of these were either Ponzi schemes, or they delivered on their promise for awhile, until they blew up in dramatic fashion.  Well known examples of both include Bernie Madoff and Long Term Capital Management.  Everyone is familiar with the former, but the later provides good context for a case study on risk assessment. 

Long Term Capital Management (LTCM for short), was a hedge fund launched in the mid ‘90s by some of the best and brightest in finance.  John Merriweather, from Salomon Brothers, started the firm.  Merriweather was Wall Street’s best bond trader in the late ‘80’s.  Tom Wolfe’s character, Sherman McCoy, from Bonfire of the Vanities was based on Merriweather.  Michael Lewis featured him in his first book, Liar’s Poker.  Merriweather assembled a team of former Salomon Brother’s traders and Nobel Laureates to form the hottest hedge fund in LTCM.   

LTCM began operations in 1994 with $1 billion in management and by 1998 they had amassed over $4.7 billion.  They focused on arbitrage strategies, buying one asset and shorting another similar asset and banking on prices converging.  This strategy can provide small, incremental gains if executed on a small scale, but if one borrows cash to execute it on a large scale the returns can be enormous.  And LTCM loved to borrow money.  Why not, when the returns appear certain?  At their height, they were leveraged 25:1; meaning that on their $4.7 billion in assets they borrowed over $129 billion dollars to execute these arbitrage strategies.  From 1994 through the end of 1997 they couldn’t lose.  They made money hand over fist, rarely suffering any setbacks.  Until it blew up in dramatic fashion when Russia defaulted on its debt obligations.   The default caused a tidal wave across all assets, obliterating every mean reversion arbitrage strategy in its path.  Within 6 months they lost everything. 

The lessons learned from LTCM and Madoff is we should be wary of the promise of consistency.  Small, incremental losses should actually be embraced in investing—we should love to lose because losing shines light on our real investment risk and helps us to understand our real exposure.  Our intolerance to losing makes us susceptible to these can’t lose propositions.  When I was trading options on floor of the Chicago Board Options Exchange one of my more memorable losses was just that—a can’t lose proposition.  It wasn’t the worst loss I every suffered, but I remember it well.  I sold a $5 call spread for $5 and lost 50 cents on the trade.  Now, in options trading there are many theoretical certainties; one of these certainties is that a call spread, or put spread, can never be worth more than the difference between the strikes.  Five dollars was the most that spread could be worth, theoretically.  Shortly after I made the trade (5 minutes to be precise, hello S.E.C), the company announced a 3:2 stock split.  The way the Option Clearing Corporation handles stock splits is by either adjusting the strikes or the deliverable shares.  The 3:2 split resulted in a quirky strike adjustment, effectively making the $5 call spread worth about $5.50.  Nothing in options theory would’ve portended the loss I experienced, but that didn’t ease my pain.  When I made the trade I thought I had risked nothing with the chance to make something small.  I was a vacationer, accepting a free meal and $150 in resort bucks, to attend a time-share pitch in Cancun.  I was lured into the situation by the prospect of low/no risk and potential reward, only to be trapped like a mouse in a trap as my downside became observable.  I made it out of Cancun with only 3 hours wasted, I was lucky.   Unfortunately, I forgot to use my resort bucks upon check out, so I felt ridiculous.  I imagine many people purchased the time-share, only to discover they could’ve bought the same deal resale on eBay for 50 cents on the dollar. 

So, the lesson learned from the option loss and vacation experience is this:  if someone says, “Come on, what’s the worst that can happen?” think long and hard about it.  Losses show us what the downside can be and therefore offer us footprints in the snow to navigate our way out of the woods.

Thanks for reading,

Zach and Dave