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| Because flipping has a $300 fee plus repair charges, I drove this real world dune buggy like a driving test for the DMV. |
Back in the real world of money, when you lose, you definitely do not get a redo on the loss. You do get more chances to lose(or win) more money if you have capital leftover or new money to plough. However for me the feeling of losing big chunks of money was so terrible in the dot com bubble that I haven't risked too much. And if you haven't lost big chunks of real world money before- you don't know exactly how you will react emotionally. Most humans will inopportunely panic sell accordingly to the studies.
Before you start constructing your portfolio, there is a tricky sticky balancing act between greed and fear. There is a conceit in Modern Portfolio Theory(MPT) that one can neatly determine how much of a return do you want and how much risk you are willing to bear to get it via a classic stock/bond split. Behold the classic balanced portfolio of 60% stocks/40% bonds. For me, this is the WRONG WRONG WRONG way to think about risk management because:
- Equities can be much higher risk than people cognitively realize, the 60/40 split could be 90% risk from stocks and 10% risk from bonds as recognized in Risk Parity but more on that later.
- Both bonds and stocks are an incredibly diverse asset class with a wide overlapping spectrum of risk. E.g. you can have utility stocks(bond proxies) that are safer than high yield bonds. REIT subsectors behave as diverse as stocks and bonds. Preferred stocks act more like bonds.
- Risks for a specific asset class do NOT remain static. Risks are heightened at different times in the economic cycle. All bonds esp. gov't treasury bond funds are going through a crazy bubble right now.
- Asset specific crises do occur. If there is a corporate credit crisis as warned by Merrill Lynch, investment grade bonds can tank more than equities. Think back to 2008. The usually safe gov't mortgage backed security darling Fannie Mae- deemed “the best business, literally, in America.” by Peter Lynch long long ago- tanked during the mortgage crisis. I picked up a few shares for a $1 having the good luck not to have bought in at $80.
- To hammer this in again, even low risk safe haven areas can have a bubble (bit redundant to point 3 and 4) and bubbles have a nasty habit of bursting. Of course treasury and sovereign bubbles never get as large as equity bubbles but you don't expect to lose 40% in a treasury ETF and if you had the underlying bond, you can hold to maturity.
- Most investors for their bond allocation do not buy the actual underlying bond but buy bond funds for ease and liquidity. 401K accounts force you to buy a bond fund and funds have bubble risk different from holding bonds to maturity.
Currently Known Systematic and Structural Risks to Cause Declines in Asset Value
- Economic cycle risk (inevitable and near)- economies are known to grow and shrink in mechanically understood cycles and it's consensus we are at the end of a historic economic boom - the likes of which the world has not seen. We should accept the dao of economic cycles.
- Overvaluation/bubble risk - everything that rises must also fall. Ironically, there are currently ample number of equities that are not overvalued and at multi-year lows, but many of the safer bonds are at all time highs as the bond rally has been ferocious.
- Credit risk(scary)- We are in the MOST leveraged condition since the invention of money. Too much debt at all levels:
- corporate debt (in my top concerns)
- The biggest fear is the BBB downgrade that may follow after a recession. You can read in excruciating detail the Morgan Stanley report too cutely titled Nature of the BBBeast.
- Is it not madness that corporations would borrow money to buy back stocks to artificially inflate stock prices instead of paying back their real debt?
- Ironically low underwriting standards may be keeping the bond market "stable" as more lower quality bonds would have defaulted in prior stricter eras causing havoc.
- bank debt - are ailing European banks dragging around bad debt more problematic than massively over-leveraged Chinese banks dragging around bad debt? Who will keel over first if government intervention isn't enough?
- gov't debt
- sovereign debt
- Many countries(U.S., Europe are at record debt to gdp ratios including the U.S.) U.S. spent 8% in interest payments in 2018, and it's the upward rate of change that is scary (7% in 2017). However one can console oneself that a good chunk of that goes to Social Security.
- Ironically, Russia has a cleaner bill of health- $0.5 trillion in debt and roughly the same in foreign currency reserves of which a significant portion is in gold.
- Lucky for Europe, a lot if their bonds are negative yielding.
- growing deficits - trillion dollars used to mean something. Can the U.S. get away with printing trillions indefinitely?
- state/local government debt - The states with the worst fiscal situation is New Jersey, Illinois, Connecticut have structural deficits.
- consumer debt
- education debt - boggles the mind there is $1.5+ trillion in U.S. alone.
- auto debt - $1.25 trillion with rising defaults
- credit card debt
- Geopolitical/political risk
- trade tensions, tariffs
- U.S. and China
- U.S. against everybody even allies- Europe, Canada, Mexico, India, Brazil
- China punishing Canada for handing over Huawei executive.
- China still punishing Korea for U.S. THAAD missile.
- Korea and Japan in a serious confrontation depriving materials for Korean semiconductor business.
- European weakness. European Central Bank has less ammunition for fixing problems given negative interest rates and the self-limiting structure of the EU. But the ailing national banks are a concern. Germany the strongest of the EU has banking problems while Italy was trying to print bonds in an alternative currency in violation of EU agreements. You only look at Deutsche Bank stock DB hovering below $7, if it drops under $5, there's a lot of institutional investors that will have to sell. You can see the index for European banks - Eurostox 7 SX72 looks dreadful as it's at a 30 year low, the current price is from 1988.
- UK- the British tend to be proud of their tradition of bumbling through chaos and that's currently the default- a hard Brexit scenario with Boris Johnson at the helm.
- China-slowing growth, Hong Kong conflicts
- South America- Argentina potential for future default with some concerns of contagion
- income inequality, political fracturing, rise of populism and nationalism
- Central Bank Ineffectiveness Risk
- Central Banks in Europe and U.S. used a lot of their arsenal since the 2008 crisis. Europe is at negative interest rates. U.S. is at least at 2%. Both have had massive quantitative easing for a decade. More stimulus after extreme periods of stimulus are not as effective as shown by Japan.
- Market & Volatility & Liquidity Risk
- Beta risk- Currently being at the long long bull market, most stocks will fall when the general markets fall. Even if you invest in a solid business with a good cash flow, it tends to fall and rise with the markets unless there is remarkable developments. Utilities/REITs/consumer staples have lower beta risk although they too will fall in a severe market downturn.
- Volatility-volatility has increased alarmingly in the last quarter with wide market swings, exacerbated by bot trading. Volatility is dangerous for the overall market esp. on the downside as it can trigger protective stop loss or stop-limit orders causing a cascade.
- Liquidity Risk
- Some ETFs have a market liquidity that the underlying assets do not. The most obvious example is high yield corp bond ETFs like HYG/JNK which can normally be bought and sold with high liquidity but the underlying corporate junk bond market is not really liquid. High Yield is $1.25 trillion market but just avoid this junk sector.
- Some funds with small market capitalization (esp. Muni CEFs) are traded thinly and so have a lot volatility that does not reflect fundamentals. But you can use this to your advantage.
- Interest rate risk - well-known and understood cyclical risks above zero. Negative interest rates are not understood. See Howard Marks memo.
- bonds and REITs are sensitive to interest rates in either direction
- low interest rate environment has forced traditionally conservative investors like me further out on the risk spectrum to get yield. I was really surprised to see Michigan Treasury bought 5 million shares of NLY stock last month(to add to their 18 million) to get that 12.5% yield. NLY is the riskiest bond based asset I own...
- Dollar risk
- devaluation/inflation risk - I've seen first hand how rapidly the dollar buys less and less in the 10 years since '08 crisis and the multiple trillions of dollars pumped in for QEs. I'll write a deep post about this as experts say are heading in a "deflationary" environment. However everything critical to human life- housing, healthcare,food is rising outrageously. The one bright area hands down where a dollar stretches further every year is in video games- a $60 of today is a quantum leap in value of yester year, and factoring in inflation, they're giving it away. (Actually Epic Games is giving away new games every two weeks in a bid to steal Steam customers.)
- currency risk
- strong dollar risk- if the dollar gets too strong, emerging market bonds denominated in dollars becomes higher risk
- reserve currency risk- the U.S. treasury market is strong since we are the de facto world currency. However China/Russia/Iran/Turkey are making deals in the yuan by passing the need for the dollar and demand for treasuries.
- Demographic Risk (inevitable)
- Most nations are experiencing a massive boomer population retirement. The U.S. is based on a consumer economy and retirees tend to spend less. If the wealthiest bulge of the population reduces consumption and will further do so in an imminent recession, we might see a deflationary cycle that is hard to break. Japan has been trying for 3 decades.
- If we have a severe market downturn (35%), will the boomers take money out of the market in a bid to staunch the bleeding and preserve what they have left and not get back into the markets? Boomers hold the greatest percentage of wealth, reducing buyers of equities overall would be another downward pressure.
- U.S. entitlement programs Social Security and Medicaid are predicated on a growing population and are now at increasing risk. See next.
- Pension crisis risk (so scary no one talks too much about it)- U.S. federal/state/local gov'ts, universities, and many institutions providing pension plans have serious shortfalls in their pension funding. The gap is estimated in the trillions and can widen during a recession. There are some deleterious knock on effects
- Higher tuition costs- universities have to payout extremely generous pension plans which take an increasingly higher portion of the budget. Just keeps on adding to the education debt crisis.
- City revenue diverted from necessary infrastructure spending to cover pension payments
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| Classic alien invasion in SimCity 2004. This game was so ahead of it's time. |
Non-Systematic Risks and Other Dangers
- Environmental Risk (real and rising)
- global warming
- increasing droughts that threaten water supply and food security which leads to political instability
- extreme temperatures, extreme storms, hurricanes
- rising sea levels
- Idiosyncratic Risks - something unique to that asset and can be diversified away
- hopefully one time company problem like a sexual harassment scandal or an E Coli outbreak
- Boeing's 737 Max problems stem from an established trend of cutting costs in software development but they are in a unique vertical. If people knew their plane's security systems was the work of subcontractors out of India that had no background in aviation being paid as low as $10/hour, they probably would avoid Boeing. Causing hundreds of deaths, there should have been more outrage and Boeings stock tanking much further. I think being included in numerous passive ETFs protected the Boeing stock.
- Disruption risk- this is a slower moving beast that one can avoid/benefit by bein open-minded and paying attention to trends
- most shopping mall retail is getting killed by on-line retail
- streaming over cable/tv
- electrification- Oil sector has taken a hit not only because of shrinking demand but perception of the environmental ills of fossil fuels and their eventual demise.
- Exotic Cosmic/Geologic Risks - something I don't lose sleep over since there is such a low probability of happening but put here for completeness.
- MSE (massive solar eruption) that damages our electricity grid. I guess bitcoin would be kaput as would be our modern financial system.
- Volcanic eruption
- (I'm not putting Impact Events/Comet even though they wiped out the dinosaurs since humans have way more on our plate.)
- Black Swan Risk - unknown unknowns that kill you. It wouldn't be the mortgage crisis since many keen observers were expecting a crisis and made quite a bag of money off their predictions. Probably it was a black swan event for the granny who was clutching her Royal Bank of Scotland stocks- she would have never predicted her $200 a share stock would still be $4 after 10 years with zero hope of regaining her initial investment.
(My risk management strategy summarized here.)
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| Making game saves expensive and precious with Saviour Snapps in Kingdom Come Deliverance. Cost of 100 groschen is no laughing matter for a poor peasant boy. |
* Not all games give you the freedom to save and reload willy nilly which players can abuse for a better outcome known as "save scumming". There are games that take a hardline against save scumming. In Kingdom Come Deliverance, you can't save unless you sleep in your bed or a inn plus you have the option to drink a liquor called Savior Snapps which is prohibitively expensive to do too often and gives you a debuff. Warhorse Studios took a huge risk in taking away the save button. I was lost in the middle of the forest and traveling at night worrying about a bandit attack. I only had 2 Savior Snapps in my satchel that I was reserving for an emergency and it really heightened the survival intensity in a way I hadn't experienced in my other savable games.
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