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Know when to hold 'em, know when to fold 'em

Readers will be pleased to know our investment analysis seldom leads us in the direction of research by the American Gaming Association. However, a recent article caught our attention, as it uncovered the key role the gambling industry plays in the American economy. In 2017, US governments at all levels - federal, state and local - received $40.8 billion in tax revenues from this rapidly growing sector. City and state administrators, boosted by these billions of dollars, were able to fund a wide range of projects and services linked to healthcare and education, in addition to other vital social and community schemes. The total tax impact per household was estimated at $343; in other words, every home in the country received a share of the taxes collected from the gaming sector last year. The moral conflict between these so-called ‘sinful’ set of businesses and the underlying benefits the tax-take brings, is clear to see.

As we know, gambling and investing share similarities, with each involving an assessment of capital to risk and choice. Moreover, investors and gamblers both look for an edge to help enhance performance and the analysis of behaviour commonly plays a role in this. A poker player will study mannerisms and betting patterns, in much the same way investors may choose to monitor trading patterns using stock charts. There are, of course, equally stark differences between the two; with time horizon and the ability to control risk at the top of this list. Gambling is a time-bound event; once it is over, the opportunity to benefit from your bet has gone, with you either winning or losing the capital you wagered. In this way, gamblers undertake speculative transactions and the opportunities to minimise losses are all but nil. By way of contrast, an investor’s greatest asset is time and the key to making money is not losing it. Being wrong on the journey is uncomfortable, but ultimately what matters is being right at the destination. Controlling risk, when an investment has taken the wrong turn is vitally important, however, this is much easier said than done, as discussed below.

Source; Advocate Capital Management

The table on the above left details the relative falls of key equity and bond indices, during the sell-off in financial markets earlier this year. The table on the right summarises the performance of some of the ‘hedges’ – indeed, 3 used by ourselves – to afford portfolios protection in the event prices headed south. These were allocations known to be held by many multi-asset managers, in the belief their uncorrelated or negatively correlated return streams would offset the falls seen across other allocations in their portfolios. As you can clearly see, the diversification benefits we and many others were looking for did not materialise and, if they did, the magnitude was inconsequential to mitigate losses elsewhere.

Source; Advocate Capital Management

Investors who decided to employ dedicated derivative positions, through this period, suffered a similar fate. The third table above, highlights how little downside protection an index put option (equity hedge) or credit default swap (bond hedge) provided at the time. To compound the issue, it is important to remember these derivatives cost money and portfolios with this insurance ‘bleed’ the cost of the premium paid during the holding period.

So why so much focus on managing downside risk?

Albert Einstein famously stated ‘Compound interest is the eighth wonder of the world. Those who understand it, earn it…..those who do not, pay it’. All investors need to respect the simplicity of compounding. As a reminder, a lump sum earning a 7% annual return over 10 years will double in nominal value. However, if the original sum falls by 50%, an investor then needs to double their money just to get back to breakeven.

The bar chart below plots the series of bear markets, endured by the S&P 500 since 1900, highlighting the average fall at 37%. If we assume the same 7% rate of return, the 59% growth required to make up this average loss would take just under 7 years. For many investors this is simply too long and it will commonly encourage either the taking of more risk, to chase returns in the hope of making up the shortfall quicker, or a decision to exit markets, just at the wrong time.

S&P 500 bear markets

Source; MFS Investment Management Company, Yardeni Research & Robert Shiller. Monthly data pre 1929.

Implications for portfolios

An aversion to losses is rational, from both an emotional perspective and using simple mathematics. As 2018 has unfolded, we have been increasingly nervous about the heightened risk of loss to invested capital and have spent a lot of our time debating portfolio diversification and investment hedges. With the benefit of hindsight, we may have been too early with our concerns about capital losses. Although, the natural bias to calibrate returns to global indices and the dominance therein of US assets does mask weaker performance in other geographies. Emerging market-domiciled equities and bonds have endured a difficult period, post the January highs, with some Asian markets – notably China – trading in bear market territory. The chart below brings this disparity to life.

Contrasting the YTD returns from China A-shares and US stocks

Source; Bloomberg

So where do we go from here?

There is no doubt sentiment feels fragile. Notwithstanding trade and other geopolitical issues, we have the Fed advising us monetary policy will no longer be accommodative and the European Central Bank is expected to begin its normalisation process shortly. Financial conditions will be tighter, as a result, adding to the uncertain landscape we have described. In our portfolio construction, we think it makes sense to emphasise caution, given the range of risks outside the baseline. Maintaining flexibility to respond to both positive and negative shocks is important too.

In positioning portfolios as we have, it is a reminder to be humble and always ask ourselves; what do we really know about the future? Investment managers are required to maximise return, for a given level of risk and need to construct portfolios to avoid everything going down at the same time, if and when things do go wrong. Sometimes investing is as much art as science, and in the words of Kenny Rodgers;

“You got to know when to hold 'em, know when to fold 'em, know when to walk away, and know when to run.”

Julia Warrander and Russell Waite

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