As I explore the field of volatility, volatility has been traditionally accepted by me as the Markowitz defined Gaussian distribution aka standard deviation. It turns out the Gaussian only is predictable in a low volatility environment. The FED has manipulated the volatility over the past 30 or so years to a low vol back drop. Over the course of that time the act of investing has become trivial. The cost of investing today is virtually zero. I trade ETF’s and stocks, transactions often several hundred K in value at a single button press for free and I can do it several times a day getting in and out of a position. In the old days such a trade would have cost thousands of dollars for a one way trip. The ease of trading makes market participation more of a video game than serious finance.
In the past couple of years my understanding has changed from a statistical model to a game theory model. In a game theory model the actual wining and losing and the how of wining and losing matters. If the Gaussian model worked in all environments I would continue to subscribe to that, but it turns out in anything BUT what is called a “short vol” environment the Gaussian model looses its predictability. My favorite picture of the loss of predictability is this picture:
The column of hot gas up to the little circle is an area of Gaussian distribution. The movement is of low volatility and quite predictable and has a name, laminar flow. At the little circle is a phase transition from linear movement to angular movement. Like the eye of a hurricane the flow undergoes a phase transition, until turbulent flow is established and in turbulent flow anything BUT predictability is the rule.
I made my portfolio into what I thought was a diversified portfolio using stocks bonds gold and cash in a set of proportions, something like 58% stocks 10% cash 5% gold 2% BTC and 25% bonds. If you subdivided my portfolio according to risk, 58 + 2 + 25 = risk on assets called short vol and 5 + 10 represented long vol so from a traditional volatility risk perspective I had an 85/15 short/long portfolio, which means I had way too much risk. When the market crashed even the gold went from a long vol asset to a short vol asset leaving me with a net 90/10 risk on v risk off portfolio. What we think we own is often far from what we actually own. When I saw ALL of the risk indexes across ALL asset classes balloon out 500%, I decided to go to the risk free asset aka CASH till I could better understand what the hell was going on. I’ve figured it out.
Left is a portfolio of so called incredible diversity. IT OUGHT TO BE BULLET PROOF. In reality the portfolio through a long vol lens is the portfolio on the right virtually undiversified. In the past I’ve written about the Harry Browne Permanent Portfolio
Through a long vol lens the PP has 50% “risk on” (VTI and EDV) and 50% “risk off” (BIL and GLD) assets, and has 1/4 of the assets devoted to economic cycles inflation, deflation, growth and recession (contraction). Recession and deflation are not the same. Growth- recession exist along a growth axis while inflation-deflation exists along an inflation axis so you can define. Growth quadrant assets are VTI/EDV. Recession assets Cash/GLD. Deflation assets Cash/GLD. Inflation assets GLD/VTI. This description is meant to show the true diversity nature of the PP. PP results need to be viewed in real terms, not nominal terms. Gaining 12% on your stocks if inflation is 15% means you had a 3% real loss. The PP for all of it’s simplicity has thrown off 4% (or so) inflation adjusted real money/yr to spend on the buying of hamburgers, and has done so at half the market risk.
Dalio add commodities and different proportions
GLD and DBC total 15%. This portfolio has 2 durations of bonds, 20 yr and about 7 years to total 55% bond exposure. If bonds weren’t hovering at going negative I’d be more interested. Hard to justify 55% of your assets being held in accounts that purposely loose money. It has been shown however with proper re-balancing techniques 2 loosing assets can yield a positive return based on the return that re-balancing alone adds to a portfolio. The Dalio portfolio can be made from low cost ETF’s
The Dragon portfolio is different in proportion, asset mix, and cost. The portfolio is more like the PP in terms of allocation. The money is spread across stocks bonds gold and 2 new asset classes commodity trend following and long vol (which is the same long vol as above in the “diversified portfolio’ picture. When analyzed over the economic regimens presented over the past about 100 years, this portfolio survived every scenario with minimal draw down net of expenses. The 60/40 had several 10 year periods when returns were negative on a real basis and when draw down was 40+%. The other problem is SORR. If you have sequential poor performance in several 10 year epochs, your perception of performance will be like the match picture above. Everything seems alright until rotation starts. There is much bla bla bla on recency bias and diversity but a portfolio is only as good as it’s anti-fragility. A 60/40 is a fragile portfolio. It’s success entirely rests on the next 40 years being a mirror of the previous 40. This is highly highly unlikely. We are in fact in a period where everything is unraveling and the FED and the Government is desperately trying to pretend things are OK. Things are not OK. The world 7.5b people owes 334 trillion in debt never happened before. 45M are unemployed, never happened before. A deadly man made virus has been released on the world with very unpredictable consequence, never happened before. Businesses are going out of business at record rates often by bankruptcy. The numbers are closing on 2008 levels (which happened over some years) but the rates are off the charts happening in only a few months. The boomers are retired so their contribution to economic productivity is over. They will consume but at a far reduced rate. Pensions are entirely underfunded so they won’t have the money they think they’ve been promised and the other 75% of society is unlikely to step up and make them whole. We viewed the Greatest gen kindly boomers will be viewed with scorn. These among many more are objections to tomorrow being a mirror of yesterday.
The Dragon has 2 active components not in the PP or Dalio. Long vol and commodity trend following. Long vol is a synthetic tail risk insurance made by using futures. An example in the futures market you can sell a call for a certain premium say $10 and buy 2 higher strike $5 calls with the premium. If the market does nothing or falls, you pocket the premium. If the market explodes beyond the higher strike, you sell your stock to the owner of the first contract you sold, but then you buy back the market at the new higher price, BUT you own 2 call options.
Market at $90 You sell $100 option and turn that cash into 2 $115 options. The market hits $100 and your stock gets sold and you pocket the money. The market hits 105 and you buy back the market with one option and have a second which grows along with your shares Market hits 120 and your stock is up 15 plus your option is up way more than 15 because its in the money. Sell the option put the money in the money in the market and sell another call and buy another 2 calls at a higher strike. Properly adjusted this technique automatically leverages your investment based on volatility. There is a short window between 100 and 105 where you are vulnerable to a small loss and there are ways to trade around that. Properly implemented you can cover the tail risk in either tail with a very small carry cost or even make a bit inflation adjusted. Artemis seems to yield a bout 1.8% in times of low volatility. So you get your tail insurance essentially for free on an inflation adjusted basis, and the risk reduction knocks the hell out of the volatility and draw down and therefore SORR risk.
Commodity trend following is somewhat similar in it’s counter cyclical implementation. Commodities tend to follow the economic cycle and are very sensitive to inflation. So if inflation spikes or crashes and you are long or short commodities you can protect your portfolio using a rules based algo. The algo would be set such that if inflation spikes you go long commodities and if deflation you go short commodities thereby protecting the purchasing power of your portfolio. Both long vol and tend following are active processes not just passive investing, but when added to stopping losses they pay for themselves. If you own a 60/40 and drop 50% you have to make back 100% to get even. That takes time, let’s say 4 years. If you drop 20% you only need recover 25% to break even. That takes only 1/4 as much time so in a year you are even and then have 3 more years to compound while the 60/40 is still under water. In addition the Dragon is quite open to the free money of re-balancing across assets. This free money is enhanced because the classes are diversified across risk on v risk off. The 60/40 has been uncorrelated for the 40 year bull bond market since 1981. Uncorrelated bonds and stocks are not the norm.
Over 30% of the time stocks and bonds are highly correlated and moderately correlated an additional 59% of the time.
So that’s a thumb nail of the Dragon. It fit’s my market prejudice and quant nature quite well. The only issue is you pretty much have to commit all your money to the strategy and once purchased you can’t really screw around with tweaking allocations or you will screw up the efficiency.
The model I use to think about this is that of a geodesic dome. A dome is made from triangles, which essentially are a strong planar surface. Somehow you need to make those planes into a volume, It turns out the maximum volume can be had with minimum surface by joining the triangles 6 to a vertex except you need 12 vertices with only 5 triangles connected. This makes a shape of exceeding strength using the smallest amount of material to enclose the volume. That has the highest efficiency. If you consider the value of your money to be what fills the volume the dome gives you the most efficient anti-fragile structure to contain and protect your money.