Ergodicity

In the course of investing we tend to glom onto recency bias. Most recently (in the past 40 years) the bias has been “buy the dip” and “60/40 fixed ratio portfolios”. Over 100 years “buy the dip” and something like a 60/40 has gone COMPLETELY bankrupt 3 times. 40 years ago was 1980 and in 1980 bond yields were 15%. In 2000 bond yields were 7%, so back of the napkin your $1000 1980 bond became a $2140 bond in 2000. Rates are near zero now (say 1%) so your 2000 $2140 bond appreciated 7x to just under 15K. This is why people trade bonds and why if you scoff at bonds you might want to gain some insight. If your 40 year bond was a zero coupon bond you would have paid $1000 in 1980 and received 15K in 2020 guaranteed a 7% per year rate of return.

In the last 40 years bonds and equities have been uncorrelated or negatively correlated, meaning as stocks vary bonds are indifferent or do the opposite. So a crash in equities means bonds yawn or in fact bonds go up as the FED lowers interest rates. In a 60/40 environment that means bonds can save you. Let’s say stocks fall in half to 30 and bonds grow to 50 by appreciation instead of being down 30% overall you would be down only 20%. This is called ergodicity. Ergodicity is anti-fragile. It adds robustness to the system. Properly balanced an ergodic system won’t crash, where as a non ergodic system is absolutely destined to failure. Every system ultimately is non ergodic as every system will succumb to the red giant our sun will become, but barring that over the course of a single lifetime, you can design an investment system that is ergodic.

It turns out over 130 years 1885 to 2015 stocks and bonds we anti-correlated only 11% of the time, moderately correlated 59% of the time and highly correlated 30% of the time. It just so happens anti-correlation has been the rule for the past 23 years, the period when most of us got rich. In the period from 1965 or so to 1997 most of us did not get rich, but most of us were in kindergarten so we were oblivious.

In 68, I was 17 and my father had a building supply business that failed. In about 65 we had a recession especially in the mid west. I was savvy enough to understand what was happening. My father’s business was quite fragile based on economic conditions. I then lived through stagflation in the 70’s and the FED reaction of increasing interest rates in the 80’s. To me that meant my medical school tuition went from 6800 to 8600 in 2 months and then from 8600 to 16,000 in one year. By my 2nd year I was basically out of money. I had enough saved in 1981 to pay for the whole thing and by 83 it was all gone, frittered away by inflation. Color my plan fragile, so I went into the Navy because no way was I going to take out a student loan with 20% interest. The Navy plan was anti-fragile. I got paid $700/mo as an Ensign and all school expenses. They paid 2 years and I served 2 years. The government soon realized they could lever their position to a 1:2 or a 1:3 position but my commission was unlevered at 1:1.

So what about retirement? What is our future? Is a 60/40 fragile or anti-fragile (much less an 80/20 90/10 or whatever foolishness you can cook up.) What kind of portfolio has a chance of being ergodic over the course of 100 years?

The answer of course is to study diversity since independent degrees of freedom are the basis of an ergodic portfolio. What the hell does that mean?

In 2008 we tried to construct my portfolio using a long volume ETF called the VXX. The portfolio was long stocks, long bonds, long gold, long commodity, long EM, and long vol in the form of VXX. VXX and commodities and EM was the wrong choice, but the idea was the right idea, and is still the right idea.

Chris Cole at Atremis capital management has a portfolio made up of

long stocks 24%

long Bonds 18%

long Gold 19%

long Volatility 21%

long commodity trend following 18%

This is a radical portfolio but it is ergodic. It back tests over 100 years as never failing. despite its cost. It is not a cheap portfolio to own. Long vol and CRB trend require active management. Long vol means creating derivatives in combination when there is asymmetric risk reward, where you can afford the carry cost to have a portion of your portfolio that explodes to the upside in the face of explosive downside. CRB trend is a means to follow momentum in either direction. CRB is an asset the government does not manipulate, hence the reason oil futures went negative a couple months ago. The government had no bid on oil, so oil actually behaved in a free market non manipulated fashion. As we see commodity prices rise in the likely coming stagflation being long commodity trends will counter balance the fragility of the stock market fomo. If you bought Hertz because it was cheap, I guess you missed it’s also dead.

This kid of portfolio is like the Harry Browne Permanent Portfolio in that it requires life long adherence for it to pay off. You can’t screw around trying to be a real estate tycoon. It’s advantage is it’s long term risk because of its diversity is minimized and of you have a lower risk at a given return you can withdraw a slightly greater draw without suffering the increased SORR.

I’ve always been attracted to the PP as an investing strategy, but to date I’ve sought the feigned security of the crowd and recency bias even though I tend to be on the perimeter of that perspective. I believe the regimen has changed. Regimens do change which is why the 60/40 went bankrupt 3 times in 100 years. I think the future is quite bleak and won’t look like the past 40 years much at all. I think the political landscape is bleak and there is much damage to be done with the stroke of a pen. I do know I absolutely can’t afford to stay in cash.

As I work through this I’ll likely write more. The geodesic dome is a structure based on the distribution of triangles across a pattern of vertices sometimes hexagonal in pattern, sometimes pentagonal in pattern dispersed across the face of a sphere. What you get is a inherently strong thin walled structure capable of distributing stress across the perimeter of the sphere the structure encloses. A Geodesic dome encloses the greatest volume for the least surface area which can be viewed as a measure of efficiency. Conceptually this is along the lines of how I view this kind of portfolio. Light weight, strong, efficient, in a word anti-fragile in the face of multiple insults.

11 Replies to “Ergodicity”

    1. It means just what it says. On a 100 year basis the 60/40 portfolio has gone the way of the dodo 3 times. You don’t think that’s possible? Look at Japan Greece and Spain. If you think a 60/40 is bullet proof you’re not paying attention. A 60/40 has done well while the bonds and stocks have been uncorrelated and bonds have been in a 35 year continuous bull market with interest going from 15% to near zero% aka the past 40 years. How much more head room exists in bonds? Essentially zero head room meaning bonds aren’t going to be around to save your butt. There is no reason to expect equities to perform either. Equities have performed because of low interest rates especially in the past decade. Companies borrow and then use the money to buy back shares with the debt raising stock price. The company is NOT worth the price because of the debt. What the hell do you think happened to 102 year old Hertz? What do you think is going to happen to the airlines and cruise lines and Boeing? So the financial engineering of stock buy back is coming home to roost the same time bond bull is ending. Add to that the dollar is crashing. CNBC is there to sell you stocks by telling you everything is OK. Everything IS NOT OK. It’s completely unclear a 60/40 retirement starting in Dec 1999 will survive 30 years. The inflation adjusted dividend reinvested return on the S&P since Dec 1999 till May 2020 is only 3.37%/yr. If you’ve been pulling off 4%/yr how much money do you have left? You still have over 9 years to go to make 30. Do you think an economy with retired baby boomers, out of control debt, and 16M long term unemployed is going to continue at 3.37% return on the S&P? Homey don’t think so.

  1. I became interested in the dragon portfolio a few months ago when I first heard of it in one of your earlier posts. I had been researching PP of various types but was nervous because many of the PP rely on bonds for a large percentage of their asset allocation and as you mentioned above , bonds don’t have much room to supply return with current rates.i looked into implementing some version of the dragon fund but had difficulty finding a way to implement it for a routine though accredited investor. I’m interested to see your thoughts on implementing something like this. Any idea what the costs for a portfolio like this would be?

    1. You get what you pay for. ArtermisCM is a hedge fund which costs 2 and 20. I haven’t figured out the trend following part but that is going to be actively managed as well. In order to make this kind of portfolio pay off you pretty much need full investment and complete conviction to the strategy. The same is true with the PP you can’t PP half the time and goose the equities half the time as that become a market timing portfolio. I think one can probably leg in however. I have zero interest in buying equities until after the election. I think the government is going to try to hyperinflate the stock market but the higher you go based on the economics of stupid the farther you fall. I have more research to do but over 9 years the long vol paid +1.8%/yr net excess of expenses meaning the insurance paid you for owning it. If I wasn’t concerned about inflation I would just likely stay cash like but I can very easily see inflation coming so I have to protect against that. The long vol is created to work in both tails, inflation and deflation so the insurance is not directional. The dragon has most of the features of Dalio’s portfolio which also uses something like a 7.5% CRB exposure and 7.5% gold but no long vol and a lot of bonds of multiple duration. The risk there is if bond yields go negative. Much to consider

  2. They’re is a fund called the mutiny fund which is a fund of funds based on long Volatility of which Artemis is one of the components. Im not sure about the other components or it’s fee structure but I think it has lower minimums than Artemis. Are you familiar with this fund?

    1. Mutiny is similar in concept but how they implement, their draw downs and their fee structure is unclear from the web site so you’d have to give them your data to find out

      1. I got some info on Mutiny From what I can see they are in business since April 2020 pretty much being run out of a bed room. They have about 100M under management, and sub contract 7 funds as their “portfolio” so it’s a fund of funds kind of model. They charge 1% and 10% or 1% and 20% depending on certain market thresholds. The problem is the funds they own charge 2% and 20% so their 1% and 10% is on top of the 2 and 20. Their hook is they allow only a min of $100K to enter the fund.

  3. Well, maybe.
    I don’t need 100 years of great performance. I’m in my fifties and still working. My portfolios is more diversified than the typical “balanced fund” you deride. But I’m not sure a mix of stocks and bonds will be so terrible.

    With some cash and owning a house. High income and low spending and balanced investing with low debt can still work over the next 20-30 years.

    Even your extreme portfolio is 42% traditional stocks and bonds. Yes, interest rates are low, but they have been for a long time. Bond still reduce volatility in a portfolio. My bonds did fine in 2000 and 2008.

    The benefit of the Permanent Portfolio came mostly from those high bond returns which -as you point out- are a thing of the past.

    There are a lot of questions around investing in “volatility” whatever that means? VIX? Can you use that to buy a house?

    And what commodities will you own and why? Oil and Gas? They don’t look so hot.

    Gold? Okay, but when will you sell? There are no dividends or cash flow. Physical gold comes with costs and risks galore. ETFs have their own issues.

    It is easy to point our fears and break things down. Not so easy to make a clear and sound portfolio for the future.

    1. So own a 60/40. No skin off my butt. How would owning a 60/40 of the Nikkei 225 and the Jap 10Y have worked out over the past 30 years?. Over 30 years the Nikkei has returned -1.579%/yr as in negative, inflation adjusted dividend reinvested. The 10Y jap bond has never done more than 2% over the past 30 yrs and presently is yielding 7 bp. Let’s see you siphon a 3.5% WR off that sucker for 30 years. I did the calc and on a simple FV basis the money is all gone at 24 years not counting SORR.

      Most of the so called diversity isn’t so diverse. A typical super well diversified portfolio when looked at through a long vol lens actually has only a 3% long vol exposure and a 97% short vol exposure aka NO DIVERSITY

  4. Curious about how you implement the gold bullion – I’ve had smart, worried friends advise that it be kept in the home as when calamity hits you can’t count on access to an electronic account.

    Appreciate the portfolio designed to withstand any down side,

    CD

    1. Hey CD

      I find the people who think owning bullion somehow protects them humorous. To own bullion, you MUST also own the means to protect what you own, else wise you don’t own it. Suppose the government outlaws bullion? The government has more guns than you. They simply haven’t thought it through, and presume the protections of society will still be in place. Guess the occupation of Seattle proves those protections are non existent. If you had 25lbs of gold in your store front and occupy Seattle took over your store, who owns that gold? My analysis is if things get that bad, having bullion won’t save you. If you have to bug out 9MM, .22 and .223 ammo is a better thing to own. Those are the most common calibers. Bullets will become rapidly scarce and increase in value, but even those will be of limited value if someone is determined to take them from you. At least with ammo you can kill some dinner. Let’s say you own 25 lbs of gold how do you trade that in the bug out? Your family is starving and someone will trade you a couple dozen eggs for 1 lb. You say NO WAY and they say adios. The spot price of gold may be 50,000/oz but the local price is 1 lb/ 2 cartons. How would you even know the spot if there was no internet?

      If you’re traveling with 25 lbs of gold what do you think the chances are of you keeping that gold? What army or seal team do you possess to defend that gold? You come across one guy with an M-60 or even an M-16 or even a .22 who shoots your kid in the head to get your attention, and your gold is his gold.

      To me it seems more risky to own bullion than digital in a total economic collapse given the fact of 300M guns in the country. Planning for collapse is not the same as planning a portfolio however. You can always own some gold bars or coins or jewelry. It’s common for Indians to have $5,000 worth of gold around their necks but if it hits the fan it won’t be around their necks for long. It’s one reason I own BTC. If you own BTC that transaction is permanently recorded in the ledger world wide. To own BTC you merely have to know the 2 numbers that define your ledger entry, so it’s eminently portable, it’s value is knowable on the market even if the network is severely crippled because every ledger is peer to peer.

      In the collapse save your last bullet for yourself and pray you never have to use it.

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