If you missed this Bloomberg piece on the unfortunate downfall of Peter Thiel’s Clarium Capital it’s a must read. It’s a story of how brilliance was once again humbled by the almighty market. The story is best summed up as follows:
“Clarium Capital Management LLC, which Thiel started in 2002 in San Francisco, fell about 23 percent in 2010, the third straight year of declines, according to investors. His fund’s assets are down about 90 percent and clients who stuck with him suffered losses of 65 percent from the mid-2008 peak.
While Thiel’s views, including predictions that the U.S. would face the threat of deflation and that the dollar and oil would rise, mostly came true, the losses reflect poor market timing and a lack of risk controls, according to several current and former clients.”
His collapse doesn’t surprise me. In 2009 I said it was pretty clear that his fund was lacking in basic risk management structures:
“As for risk management – it doesn’t sound like Thiel is a big fan as leverage is often 3x -8x and positions are focused solely on a few macro themes.”
Of course, Thiel is a brilliant man and his successes in life are well documented, however, success in one industry by no means makes you a great investor and it certainly doesn’t make you a great portfolio manager. But in every great collapse lies a great lesson to be learned so Thiel’s losses are not without gain (unless you’re one of his investors). The most important takeaway from Thiel’s experience comes from the second paragraph of the article:
“It doesn’t matter if a manager is correct in his long- term views if they don’t get the timing right or manage volatility along the way,” said Don Steinbrugge, managing partner of Agecroft Partners, a Richmond, Virginia-based consulting firm that advises investors and hedge funds.
Managing volatility is risk management. It’s a term on Wall Street that is too often overlooked and taken for granted. Most investors have no idea that their portfolio managers have weak risk adjusted returns. Most investors are unaware of the fact that most portfolio managers take unnecessary risks and manage portfolios not for client returns, but for the institution they work for. Risk management is important because the trek to the top of the investment mountain is fraught with risks. Last year I wrote:
“I’m not pessimistic by nature. In fact, I am quite the optimist (I was very optimistic about the U.S. stock market even at the beginning of 2009). But I view the trek up to the top of the investment mountain as being full of risks. Seeing butterflies and rainbows sure make the trek more enjoyable, but won’t guarantee that you ever get there (just ask the millions of baby boomers who have been fooled by the myths of buy, hold & hope!). Anyone can get caught up in the beauty and wonder of a butterfly or a rainbow (or a bull market!), but it’s the cautious observant who steers you clear of the loose rocks and the avalanche attached. If you don’t watch out for potential pitfalls I guarantee that you’ll never get to the top of the mountain.”
Risk management essentially involves the admission that you are going to be wrong, that you are going to run into loose rocks along the way. There is a tendency to punish everyone in the investment world who is ever wrong. Some people take great pleasure in trying to prove that other investors are just as bad as they are. The truth is, we all make mistakes, but some people prepare for it and others don’t.
In large part, this admission involves the acknowledgment that you could be the absolute smartest person in the room, however, there is a chance that no one will agree with you. This is the classic Keynes beauty contest where participants are asked to choose the most beautiful contestant from a group and the participants who pick the most often chosen face are eligible for a prize. As Keynes said:
“It is not a case of choosing those that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”
You might have distinct inside knowledge that 1 of the contestants is in fact the most beautiful, however, if the crowd doesn’t see it this way it really doesn’t matter. You will still lose. The market is the same way. You can be the most brilliant of the lot, but if the market doesn’t agree with you it matters not. Therefore, you have to be willing to accept all outcomes. Being dogmatic in the investment world is like burying yourself on a knife. This is not a place for ideologues or politics. As I mentioned the other day, the market does not care about your political affiliation, your personal feelings or your personal beliefs. Therefore, you must be willing to accept that you are going to be wrong. I am wrong all the time. It happens in this business. But I’ve created a flexible approach to investing that helps hedge me from my own ignorance.
Some investors create flexibility in a portfolio by hedging positions. Others use multiple strategies. Others diversify (true diversification). Below is an outline you can follow that will help you create a flexible portfolio and hopefully avoid your own implosion or underperformance:
1) Always be flexible and never stay married to a loser. The beauty of the stock market is that polygamy is perfectly acceptable. Never get married to a particular position or a particular strategy. The market is complex, dynamic and always evolving. Learn to change with it if necessary. No two investment environments will ever be the same so it’s not rational to believe that you have found some holy grail strategy that will never fail. A static or rigid strategy is a sure way to lose. In the case of Thiel, it’s clear that he was using leverage to essentially double down on a thesis that was wrong in the short-term. As JM Keynes said we must always remember that the market can remain irrational longer than we can remain solvent. A static approach will create losers and losers have no place for a portfolio. Cut your losers – even if it’s an entire approach.
2) Use multiple asset classes and create non-correlation if possible. This is why most investors fail in the market. They learn one strategy or one asset class and when that one approach stops working they’re a sitting duck. Trading one asset class with one directional bias would be like a professional baseball pitcher deciding to throw nothing but fastballs. You have many options and pitches – utilize them all. Learn to diversify your strategies AND investments. This might involve using multiple strategies (my preference) or it might involve using several different asset classes. Jim Cramer is right: there’s always a bull market somewhere. One of the primary reasons why global macro funds perform well when compared to other fund styles is due to their diversification overkill. A good risk manager can be long Yen, short dollars, long Fed Fund futures, short gold, long Chinese equity and short GM debt all at once. You don’t have to pigeon hole yourself in this world. You can be flexible in this world. Take advantage of it. The greatest part about the mass financialization of our economy is that investors have choices now. Learn to reach into a different bag of tricks if you need to.
3) Don’t be emotionally biased. You might be trained to believe that buying stocks is the best way to invest in a market. You therefore ignore the other side of trades or other asset classes. This bias can lead to a permabull perspective (or a permabear perspective for the more pessimistic) or other extreme biases that make you susceptible to underperformance. Learning to be unbiased and flexible are perhaps the two most important rules to becoming a good investor.
4) Never stop learning and recognize that you know less than you think you know. The global economy is the greatest puzzle known to man. To my knowledge no one has yet solved it. It is dynamic, interesting and above all else important. Understanding the entire system is vital to learning how to understand risk and better manage your money. Most investors think they understand investments by picking up a book about dividend paying stocks. But if you don’t understand how the global economy, currencies, and a multitude of other variables influence that stock’s performance you truly can’t even begin to fathom what risk management is.
5) Create rules within your approach AND FOLLOW THEM. Your strategies should not be rigid, but your implementation of them should be. I like to think of myself as a robot when I invest. Some of my strategies are literally automated, however, if you don’t have software or the knowledge to create automated systematic approaches you should still create rules that remove the emotion from your approach. This is no place for cry babies, excuses or arrogance. If you allow the market to do it she will break you down and she will humble you. Having rules will help you remove the emotion from your investment approach and help ensure that you don’t suffer catastrophic losses.