Two Roads Diverged

I keep thinking about the book Safe Haven and Mark Spitznagel’s preferred methods of investing. I’m struck with how similarly we view the nature of investing markets, but how differently we approach investing. How can we agree on the same ultimate challenge (maximizing the geometric return), and then form such different solutions to the problem?

Analysis of the Investing Challenge

I stated before, the first half of Spitznagel’s book holds many similarities with this blog. Others have thought this too.

Now @epicphilos’s praise is a probably a little high, as the book in my opinion is very good and very readable. But I do think the comparison is apt (read “The Foundation” in the University for a flavor of the similarities).

We both believe one must view the markets through the lens of the geometric return. When you do, you start to see hidden edges.

Evaluation of Safe Havens:

Once Spitznagel makes the power of the geometric return clear, he explores ways to improve stock market returns. He examines many different assets to see if they improve a portfolio’s geometric return.  He calls these assets safe havens.

Cutting to the chase, he systematically rejects nearly everything.  He rejects hedge funds, he rejects trend following, he rejects cash, Swiss Franc, Japanese Yen, private equity, momentum, min-vol, farmland, and commodities.

Interestingly, he even rejects long vol and generic tail hedging strategies (he clearly doesn’t view his version as generic).

He “fails to reject” three things: gold, long term treasury bonds, and “insurance”. 

Two Roads Diverge…

I’ve explored combining stocks with most of the items he listed. I can also only justify adding treasury bonds and gold to stocks. If you seek higher returns, most other diversifiers won’t help. We are still in sync with our views here.

But Spitznagel doubles down and says bonds and gold had lucky runs during his test period. He doesn’t think you can trust them. He views insurance–his version of tail hedging–as the only true portfolio enhancer.

I, of course, don’t use insurance in Geometric Balancing, but I do use gold and treasuries. Therefore our investing paths diverge.¹ We’ve reached different conclusions on how to implement nearly identical investment philosophy views.

We both realize the importance of the geometric return–yet we chose to travel down different roads.

This contrast really intrigues me. So I’ve tried to understand it, and came to three conclusions:

1. Spitznagel doesn’t evaluate the other assets dynamically. He looks at static allocations. I’ve never viewed static allocations as the correct approach because the investing world isn’t static.
2. I suspect he looks at allocations statically because he doesn’t believe standard deviation and correlation are predictable. I think they are somewhat predictable because they cluster. This is likely the core reason why he rejects gold and bonds, and I embrace them.
3. But maybe more importantly, Spitznagel seems to know how to make “insurance” work.² As I said in my last post, I don’t know how to walk down this road. Time to fix that.

The Power of Writing

Writing this blog has really helped crystalize my thoughts on certain investing topics. I try very hard to make these posts understandable to a wide audience. This means that many ideas and concepts I’ve taken for granted or just “understood” for years can’t simply be stated as such. I’ve tried to explain the background clearly. I’ve gotten to dive back into old ideas and break them down for public consumption.

I can’t tell you how valuable it is to move a thought from your head into written words and charts that you want someone else to understand. Sometimes it deepens your original understanding of a topic. And sometimes you find that there was another layer of depth that your earlier self never noticed (see this and this for more on this idea).

So I decided to write about tail hedging to see what questions it exposed, which is why I wrote the last post. Doing so definitely created some interesting questions. Foremost: What should an options price “fair value” actually be? Can you run a Shannon’s demon strategy purely with options and the underlying asset?

So there will be more posts on tail hedging soon.

Monetization is the Key

I’ve started tracking a conceptual options strategy. It’s still very raw. Instead of keeping it private I figured I would post it here so others can see.

For now, I’m only going to say this about the strategy:

• I’m going to assume for the moment that the market for SPY options is essentially efficient. What “efficient” means in terms of options is an interesting question (which I will explore in a future post). But the options market for the S&P 500 is large and if markets work, it’s got to be fairly close to some equilibrium.
• They key to success then comes from the monetization strategy. When and how do you sell the options? The concepts of rebalancing and Shannon’s demon still apply to options, they are just more complicated. A good monetization strategy should be built around that idea.
• As with any strategy built around rebalancing, proper position sizing is critical.

Two Roads Converge?

I think Spitznagel is correct: properly constructed “insurance” should help a portfolio over the long term. However I know that when properly sized, gold and bonds also improve your portfolio. Right now these two paths diverge. But I keep wondering: what would happen if I could combine these two roads together?

I believe that road is untraveled and taking it might make all the difference.

Not Investment Advice

I want to be very clear: DO NOT COPY THIS. I’m not investing in any of these options in real life. This is a paper exercise.³ I’m just trying to learn and I’m sharing so that if something useful comes from it, you can learn too. I will update this every weekend for as long as I find it interesting and useful.

Footnotes:

1-This is obviously a Robert Frost allusion. Safe Haven ends with a modified Robert Frost Quote. And I of course have my own allusion to the poem.

2-My opinion is that many tail protection strategies don’t “work” and are more for peace of mind than for portfolio enhancement. But there are a small handful that do seem to truly help portfolios.

3-Frankly, I think this strategy is too simple, but I think it might get close to providing a benefit. I think most tail strategies also sell some part of the options surface to “fund” their tail purchases, and I don’t want to get into that yet. It’s also built to blend with a certain amount of geometric balancing, not just any other portfolio, which is another reason to not copy it.