Why Risk Management Will Not Produce The Best Investing Returns
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Note: This article is based on a recent letter that I sent to my partners at Silver Ring Value Partners
Risk management will not produce the best returns.
What?? Then why do it? Because we don’t know the future. Allow me to illustrate what I mean with an example using the current environment. Imagine that there are two very different scenarios possible from this point with respect to how the economy and the stock market will be impacted by the Coronavirus crisis:
A. The Benign Scenario: Coronavirus blows over in a few months as prevention measures and warmer weather help. We avoid a full-blown recession, most businesses recover by year-end, except perhaps a few of the most affected that take a bit longer. Markets stabilize and investing returns to normal.
B. The Gloomy Scenario: The health impact on our society is far more severe than we hope. The global economy is tipped into a deep, multi-year recession. This recession is accompanied by an initial credit crisis that causes many financially levered companies reliant on the capital markets to go bankrupt. Many other companies’ profit streams are depressed for many years to come. Stock markets spiral downwards for years before stabilizing.
Now, let’s suppose that we have three portfolio managers that each pursue a very different approach:
Cautious Claire: Claire believes that the Gloomy Scenario described earlier is going to come to pass. She loads her portfolio with cash and extremely safe, but at best only moderately undervalued defensive stocks that can withstand any environment. If the world recovers quickly her results will be underwhelming, but she knows that’s not the way things are going to play out, so that doesn’t enter into her decision-making process.
Aggressive Anne: Anne believes that the Benign Scenario described above is going to happen. She invests in every beaten-down stock that she can find that will benefit from a quick recovery, but which might go bankrupt if one doesn’t happen. No matter, she is sure in her view of the path the world is about to take.
Prudent Paula: Paula is not sure which of the two scenarios is going to come to pass. She wants ensure that her portfolio does at least OK no matter what happens, and does well in the scenario that she believes to be more likely. She constructs her portfolio with some very safe investments with a moderate amount of expected returns, combined with some aggressive investments that have more risk but that are likely to do much better in the Benign Scenario. As she searches for investment opportunities for her aggressive investments she does not necessarily pick those that can go up the most if the Benign Scenario were to come to pass, but also considers these companies’ ability to survive if that scenario is delayed or not quite as benign as she had hoped.
Now, imagine what happens if each of the two scenarios actually comes to pass:
The Gloomy Scenario happens: Cautious Claire looks like the paragon of investing wisdom. Magazines rush to interview her. She appears on cable news channels talking about her investment process. “How did you do so well when many others have come up short?” “Well, there was this one moment when I just knew how it was all going to play out. I sold all my old investments and prepared for Doom and Gloom. My clients have benefited enormously, and I have had an influx of new ones beating down my door to be able to share in the fruits of my wisdom in the future.”
In the same articles and TV interviews where Cautious Claire’s virtues are extolled, Aggressive Anne is mentioned in passing, derisively. “What was she thinking?” “Didn’t she know we were heading for Doom and Gloom?” “How could she have done so poorly for her clients?”
Nobody mentions Prudent Paula at all. She did well, but her results didn’t stand out compared to Cautious Claire.
The Benign Scenario happens: Aggressive Anne looks like an investing genius. Magazines rush to interview her. She appears on cable news channels talking about her investment process. “How did you do so well when many others have come up short?” “Well, there was this one moment when I just knew how it was all going to play out. I sold all my old investments and prepared for a quick recovery. My clients have benefited enormously, and I have had an influx of new ones beating down my door to be able to share in the fruits of my wisdom in the future.”
In the same articles and TV interviews where Aggressive Anne’s virtues are extolled, Cautious Claire is mentioned in passing, derisively. “What was she thinking?” “Didn’t she know we were heading for a quick rebound?” “How could she have missed such an amazing opportunity to make money for her clients?”
Nobody mentions Prudent Paula at all. She did well, but her results didn’t stand out compared to Aggressive Anne.
What I hope the above imaginary example illustrates is that there is going to be a massive outcome bias after we know how this all plays out. The winner will write their narrative and imbue their sometimes just plain lucky outcomes with skill and foresight that wasn’t really there at the time the decisions were being made. That won’t matter, because most observers will be dazzled by their spectacular results relative to the rest of the field and will not question how well that same investor would have done had the world taken a different path.
There is only one problem. Right now, before we know how it is going to play out is when we have to make our decisions. Betting on one particular macro outcome in a way that you will do really poorly if it doesn’t occur is not investing; it is just speculating. In the same way that casino gamblers don’t know if the roulette ball will land on red or on black before the wheel is spun, neither can we be sure of how the world will play out during the current crisis.
If you are a serious investor and care about both preserving your capital and growing it at attractive rates over the long-term, the implication is clear: you need to construct a portfolio that doesn’t do terribly in any outcome and that does well across many of the paths the world might take. In no path will your results, after the fact, be as attractive as if you had optimized your portfolio for that specific path. That’s why risk management does not produce the best returns. It is because as we manage risk we tax our outcome in each path to ensure that if the world takes a different path that we still do OK.
Note: An earlier version of this article was published on Forbes.com
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