Podcast Summary
The Unpredictability of Investing: Investing involves dealing with complex systems that defy simple formulas. Despite relying on algorithms, predicting market outcomes with certainty is impossible. Embrace profound agnosticism as a strategy to balance risk across asset classes.
Learning from this podcast episode is that just like in physics where there is no algorithm to predict the exact position of three interacting bodies in the future, investing also involves dealing with complex systems that defy simple formulas. The guest, Ben Hunt, emphasizes that investors, whether value or growth-oriented, rely on algorithms to make sense of the investing world. However, Poincare's 3 body problem shows us that even with all the available information, it's impossible to predict market outcomes with certainty. Therefore, Hunt suggests a strategy called profound agnosticism, which is a risk parity-like approach, as a more appropriate investment strategy in an uncertain world. This strategy aims to balance risk across different asset classes rather than trying to predict market movements.
Investing in a world of multiple influential entities: The presence of central banks and other influential entities can alter traditional investment principles, necessitating a profound agnostic approach
The presence of multiple influential entities, such as central banks, can significantly alter traditional investment principles, creating a complex and unpredictable environment. The three body problem in space serves as an analogy for this concept, where no formula exists to predict the outcome due to the constant interaction between three bodies. Similarly, in investing, the introduction of massive central bank interventions has added a new gravitational force, challenging long-held beliefs about the importance of quality, value, and price in determining returns. For instance, the growth of the S&P 500 index versus a long-short portfolio of quality metrics or a long-short value versus growth portfolio demonstrates this shift, with value underperforming and growth outperforming. This new reality necessitates a profound agnostic approach to investing, acknowledging that our fundamental views and algorithms may not hold true in all circumstances.
Central banks' large-scale asset purchases push investors towards riskier assets: Central banks' actions reduce risk-taking in the real economy, leading to a scarcity of secular growth and a corresponding increase in its value. Value investing is challenging in this market environment.
Large-scale asset purchases by central banks force investors to take on more risk in order to maintain expected returns. This phenomenon, known as the "pushing out of the risk curve," has led to a significant premium on secular growth over value stocks. Central banks' actions reduce risk-taking in the real economy, leading to a scarcity of secular growth and a corresponding increase in its value. For investors, it's crucial to understand their own investing style and adapt to changing market conditions, but staying true to one's investment DNA is also essential. The current market environment, shaped by massive asset purchases, has made value investing particularly challenging.
Agnostic investing approach with risk budget: Risk parity strategy involves setting a risk budget, adjusting portfolio exposures mechanistically, and diversifying across asset classes and geographies to cope with market unpredictability.
A profoundly agnostic approach to investing, such as risk parity, involves having a risk or volatility budget and adjusting portfolio exposures mechanistically based on market conditions, rather than relying on personal views or algorithms. This approach, which can include diversified exposure to various asset classes and geographies, aims to cope with the unpredictability of markets and adapt to changing volatility regimes. The common criticism of risk parity being a levered bond portfolio may hold true in certain environments, but the strategies are more complex than that. Managers who implement these strategies have a barge-like approach, meaning they consider multiple factors and geographies within each asset class to ensure diversification and reduce correlation. Initially, I shared this skepticism, but after gaining a deeper understanding of the strategies, I came to appreciate their benefits in navigating the complexities of today's markets. Despite the past success of risk parity in a declining interest rate environment, its adaptability to various market conditions makes it an attractive option for investors looking for a cost-effective way to take on the world's risks.
Dynamic portfolio strategies adjust risk allocations effectively: Dynamic portfolio strategies can help mitigate risk by adjusting allocations to large asset classes and promoting diversification beyond stocks and bonds.
Dynamic portfolio strategies, despite the criticism of potential amplified market movements during market downturns, have the ability to adjust risk allocations effectively when considering a longer time horizon. These strategies, which can be compared to "barges" that change risk allocations to large asset classes slowly, help mitigate the risk of being overly levered or weighted to any one asset class or sector. The dynamic nature of these strategies, combined with a diversified portfolio that includes assets beyond stocks and bonds, can lead to a risk-balanced or risk-parity approach. At Salient, the firm's focus on agnosticism and niche asset classes allows the chief investment strategist to interact with individual teams, providing guidance and support in implementing dynamic portfolio strategies that adapt to the ever-changing investment landscape.
Trusting your process and having faith in your abilities: Investors should focus on their process, trust their abilities, and have faith in their decisions, especially during uncertain times. Proper risk allocation is crucial, and valuable information can be gained in private markets to make informed decisions.
In the world of investing, it's essential to trust and believe in your process rather than constantly searching for external answers. A coach or counselor can help prevent the natural tendency to flail when things aren't going as planned. The concept of profound agnosticism encourages faith in your ability and your process, as you've told your investors what you'll do, so focus on executing that. In the financial advice industry, the emphasis should be on proper risk allocation, as taking the right amount of risk is the most crucial decision for any investor. Although uncertainty and potential enormous returns come with risk in private markets, it's still possible to gain valuable information and make informed decisions. The difference between public and private markets lies in the availability of private information, which is legal in private markets but essentially illegal in public markets.
Focusing on behavioral aspects and new technologies for alpha in public markets: Momentum and trend driven by fear and greed provide persistent alpha sources. Private investments offer legal private information. Thinking differently about behavioral aspects can uncover unique opportunities.
True alpha, or private information, is rare in public markets today. However, there are still opportunities for alpha in public markets by focusing on behavioral aspects and utilizing new technologies. Momentum or trend, driven by fear and greed, is a persistent alpha source. Private investments, where legal private information can be obtained, and public markets with a risk-balanced approach are other areas for investment. The speaker also emphasized the importance of thinking differently and freshly about behavioral aspects of individual markets. Regarding the farm example, the speaker highlighted the importance of private information and the opportunity to find alpha through unique perspectives.
Lessons from farming and investing: Both farming and investing require an appreciation for cyclicality and protecting reputation, as unpredictable elements and broken reputations are difficult to recover from.
Working with animals and the land on a farm, much like investing, requires an appreciation for cyclicality and the importance of protecting one's reputation. The speaker, who has a background in investing and runs a farm with various animals including bees, emphasizes the lessons learned from this experience. He explains that both farming and investing involve working with unpredictable elements and the importance of living to fight another day. He also stresses the importance of protecting one's reputation in both ventures, as a broken reputation cannot be easily repaired. The speaker believes that by communicating these observations in relatable ways, such as comparing market cycles to the behavior of animals on a farm, he can help financial advisors have more effective conversations with their clients.
Investing requires self-reflection and adapting to changing market conditions, like bees navigating by the sun: Effective investors recognize and manage basis risk, the potential discrepancy between related factors, for informed decisions and market navigation
Being an investor requires critical self-reflection, just as important as understanding market theories and algorithms. The bee's ability to measure light angles and navigate based on the sun's position serves as an analogy for investors' need to adapt and adjust based on changing market conditions. Bees are effective risk managers, and understanding the concept of basis risk, which refers to the potential discrepancy between the relationship between two related factors, can help investors assess and manage risk. In the context of the bees, basis risk refers to the potential difference between the relationship between temperature changes and the sun's angle. By recognizing and managing basis risk, investors can make informed decisions and effectively navigate the market.
Managing Personal Risks in an Unpredictable Market: Considering personal risks and the bigger picture is crucial in managing risk effectively in the unpredictable investment industry. Honest decisions prioritizing clients' interests can outweigh potential personal gains.
In today's investment world, there is a high degree of uncertainty and unpredictability, similar to the unpredictable weather patterns in "Game of Thrones," making it difficult to manage risk effectively. Personal risks, such as those taken during critical moments in one's career, can sometimes be more manageable than the unmanageable basis risk present in the investment industry. An example of this was in September 2008 when the speaker, running a long short fund, was experiencing significant success and had taken a large position in credit default swaps. However, they realized that if the entire system collapsed, their fund's success would not matter. This moment served as a reminder of the importance of considering the bigger picture and the potential consequences of personal gains in an unstable market. Another example of taking a personal risk was when the speaker's fund was not performing well, and they decided to give all the money back to their clients. While it seemed like a huge risk at the time, it was an honest decision that prioritized their clients' interests over their own. These experiences highlight the importance of considering personal risks and the bigger picture in the context of the unpredictable investment world.
Understanding the natural processes behind things: Being authentic and honest, even in difficult situations, can lead to greater rewards and appreciation for natural processes
Being honest with yourself and others, even if it means winding down a successful business or acknowledging the realities of where food comes from, can lead to greater rewards in the long run. Protecting your reputation and being authentic in your actions, no matter what industry you're in, is essential. The idea of a "fingernail clean" egg is an analogy for understanding the natural processes behind things we've come to consider normal and clean. Fresh eggs, for example, have a protective film on them that keeps them from getting contaminated. However, when eggs are mass-produced in factories, they require refrigeration and scrubbing to prevent bacterial growth due to the unnatural living conditions for the chickens. By understanding the underlying truths, we can make more informed decisions and appreciate the value of authenticity.
The importance of quality over scale in certain industries: Not everything that scales is high quality, and not everything high quality can be easily packaged and scaled. Recognize this in business and investing.
Many things we consider natural and necessary in our modern world, such as industrially produced eggs and exchange-traded funds (ETFs), exist primarily because they can be scaled up for mass production, not necessarily because they are inherently good or high quality. This is particularly true in the financial industry, where companies and investment strategies must have enormous scale to survive. However, quality opportunities may still exist in private markets where scale is not as critical. It's essential to recognize that not everything that scales is high quality, and not everything that is high quality can be easily packaged and scaled. It's a valuable lesson for businesses and investors alike.
Understanding complex phenomena with AI: AI can help us analyze unstructured data and identify forward-looking behavioral patterns, leading to new insights and understanding.
While traditional algorithms are useful for basic analysis, they fall short when it comes to differentiating businesses or understanding complex phenomena like markets and human behavior. The speaker is particularly intrigued by the role of narrative and the computational rules of narrative in natural language processing, which falls under the umbrella of artificial intelligence. He emphasizes that AI won't make regressions run faster, but it can help us understand unstructured data, such as communications and words, and identify forward-looking behavioral patterns. The speaker is excited about the potential of AI to help us visualize and make sense of vast oceans of words and communications for the first time, leading to new insights and understanding, rather than a specific tool or formula for investing. He acknowledges the frustration of not being able to predict specific outcomes but emphasizes the value of understanding the dynamics of the game or system.
Embracing challenges and learning from them: Adopting an adaptive and agnostic approach to overcome losses in farming or investing, and the importance of forgiveness as a kind gesture.
Understanding the human dynamics of a system, whether it's farming or investing, requires embracing the inevitable challenges and learning from them. Patrick O'Shaughnessy's conversation with the farmer highlighted the emotional aspect of accepting losses, whether it's the death of an animal or an underperforming investment. This adaptive and agnostic approach allows us to grow and make better decisions in the future. Another memorable moment from the conversation was the importance of forgiveness as a kind gesture. These human experiences serve as reminders to approach challenges with grace and resilience.
