By |Published On: December 29th, 2023|Categories: Research Insights, Guest Posts|

There is nothing new, except what has been forgotten.

Marie Antoinette

The world is complex and ever-changing; news travels at warp speed, events happen fast, and popular narratives can distract and mislead us. Many risks important for our portfolios are new, hidden, or nuanced in some underappreciated way—and likely to be misunderstood and mispriced in the markets. Other risks can hide in plain sight. Good risk management can be described as a balancing act that employs the first principles of investing, lessons from history, behavioral psychology, a little math, and even our own imagination in service of our objective: to detect and defend against the risks we can foresee and fortify our portfolios against those we cannot. In short: we need informed creativity, not calculation.

“Grey Swans” and timeless patterns of investment risk

White Swans are risk events that figure prominently on most investors’ radar. Well-known economic and market White Swans include, among others, hyperinflations, leverage-induced booms and busts, age-related demographic cliffs, moral hazard build-up in the economy, and high asset valuations that leave no margin for error. Sound familiar?

And yet, many of the White Swan risks that could really hurt us are new in some important way, context-dependent, or forgotten about. These risk variants—let’s call them Grey Swans—are less likely reflected in market prices, so there is great value in trying to discover where, and how, they emerge—so that we can diversify them or hedge them outright while we still have the chance.

Several age-old drivers of Grey Swan risk seem to elude us frustratingly often:

  • Sudden relative changes can create risks that absolute levels mask. People and markets get used to conditions as they are. Abrupt changes to the status quo ante—in the economy, in geopolitics, in financial asset prices—can create shocks beyond what we would expect from a new (absolute) reality alone. The risk is even more insidious if the “destination” is not in itself alarming or anomalous. (The rapidity of the 2022 surge in global interest rates is a textbook example; a 5% government bond yield might be safe, or very risky, depending on whether we spent the prior decade at 4% or 1%.)
  • Risk creeps into the system via distorted incentives. To understand the risks that can emerge from misaligned incentives—a common feature in markets—requires a mode of analysis distinct from traditional risk modeling. (Put the Value at Risk model back on the shelf, here, and in its place draw up a game theory payoff matrix to paint a micro-to-macro picture of risk.) A live example: Canada, in late 2022, announced it will cease the issuance of inflation-linked bonds. What if other large, heavily indebted Western governments were to follow suit? Hmm.
  • Risk hides in complexity. Complexity comes in many forms. There are complex assets and instruments; complex portfolio strategies and operations; and the complexity that results from great interdisciplinary challenges, which require us to make decisions despite large knowledge gaps. (Think: managing through a pandemic requires insights from the life sciences, economics, and government policy.) Something complex can be especially pernicious when it is a close cousin of something we are familiar with (consider “CDO-Squareds” in the pre-Great Financial Crisis days).
  • Our bias toward oversimplification can lead us to understate and overstate White Swan risks. People prefer simple explanations and narratives that fit their worldview. Risk emerges when nuance is ignored. Consider the narrative that de-globalization will inexorably intensify in the coming years, along with its attendant risks (stagflation and geopolitical fracture). Is the reality that simple? What if instead we see re-globalization—a more nuanced reconfiguration of global economic linkages—but not their destruction? An example more directly related to our investments: leverage. “How much” barely scratches the surface. Leverage quality is at least as important. Is the financing long-term or short-term? Can the lender “put” the debt back to you (i.e., cut your financing) or, more surreptitiously, change collateral requirements on the fly? Yes? Under what circumstances? How likely are those circumstances, and do they correlate with “Bad Times”? Nuance matters. Simplicity can lead us to misestimate obvious risks and fail to grasp, entirely, more subtle risks (and opportunities).
  • Risk emerges from the (misguided) belief in stationary characteristics and relationships. Asset behaviors are always context-dependent. Asset classes are uncorrelated until they’re not; liability risks are uncorrelated until they’re not; assets hedge liabilities until they don’t. Diversification can fail. Consider the very notion of a “safe asset”. At best, an asset can be conditionally safe, depending on the way it behaves in a particular environment. The safest asset one could own during a hyperinflation might be traditionally considered the riskiest: a volatile real asset levered to the max with long-term, fixed rate debt, non-puttable debt. Alternatively, a safe haven during the last crisis might be the only asset fully wiped out in the next. (Witness agricultural land in post-WWII Japan.) Related: a safe asset becomes risky at the wrong price. You can overpay for good assets. (Recall long-duration bonds at the end of 2021, with interest rates near forever-lows but nominal growth and inflation surging.)
  • The global economy’s nonlinear dynamics mask certain risks and distort others. Our brains are not wired to appreciate nonlinearities. Hemingway nailed it in his classic The Sun Also Rises: “How did you go bankrupt?”… “Gradually, then suddenly.” (The good news: we tend to underappreciate nonlinear positive developments too.)
  • Excess belief in rationality can mask the (true) probability of risk events. During the Great Depression, Britain held out against suspending the gold standard far longer than would have been economically rational; to abandon gold would be dishonorable! For a modern example: some studies show that nearly half (!) of jobs in developed economies could be automated…and soon. But not so fast; as leading technologist Erik Brynjolfsson has reminded us, we often neglect to consider the subtle—but formidable—cultural barriers to more rapid adoption. The upshot: behavior is tricky to model. Don’t assume that what can or should happen will happen.
  • Risk rises in step with our overconfidence in what we (think we) know. The banking business model (borrowing short, lending long) is basic and centuries old. Surely by 2023 we fully understood its risks? Well, throw in a dose of modern technology—social media and app-based mobile banking—and suddenly “run risk” needs to be wholly reconsidered. (The risk level becomes grave when individual overconfidence turns into market-wide collective delusion.) The lesson: revisit everything you know from time to time and question your core beliefs. Then keep on doing so…forever.

…and there may well be more.

Bottom line: White Swan risks can hide in plain sight. And some risks we miss because they’re so huge; we see the trees but miss the forest. Many White Swans, upon closer scrutiny, quickly start to look…rather grey.

“Deep Risks” – A Unique Class of Grey Swan

Certain risk events are familiar, at least in concept, but typically more severe—possibly life-ending. They are the “deep risks” that lurk in the more distant tails of the probability distribution of potential outcomes. These are risks that we may never have experienced in our careers; risks that may not have occurred for decades or centuries; risks that may have occurred only in foreign lands; or risks that may never have occurred. Think: nuclear annihilation or severe wars that permanently destroy the capital stock; climate catastrophes; bio-warfare; severe and irreparable data breaches; sudden coups that overthrow “stable” governments; AI run amok…the list goes on.

To appreciate these deep risks, we need an awareness of history, a great imagination, and some common sense. During extreme but non-existential crises, some historical patterns do emerge: expropriation and redistribution, limits on the free flow of capital, sudden losses in market liquidity (even extended market closures), forced asset sales, counterparty failures, confusion, and mass hysteria. But while it is useful to be aware of such risks, it is not clear what exactly can be done about them. How do markets price these risks? They probably don’t. The more extreme and abstract the risk, the less likely it is reflected in today’s pricing. Hedging or managing deep risks is difficult if not impossible. But worry only a little bit; many of these risks are too big to matter for our investment portfolios.

“Black Swans”

True Black Swans are events that no one is thinking about or has contemplated. By definition, they are impossible to foresee and lack historical precedent. For that reason, they are the least likely to be priced in financial markets and the most likely to hurt us. Their sources are myriad and defy common patterns. So, can we say anything useful about such unfamiliar risks? Black Swans can emerge from innovation. Rapid technological change leads to new things being used in new ways, and potentially, wholly new types of risk that we don’t currently know exist…or that don’t exist just yet but soon will. My most optimistic take on Black Swan risks is that, if we’re lucky, they might exist in our imagination. And they’re not all negative! If the history of industrial revolutions and total factor productivity growth is any guide, the arc of human progress is one giant (positive) Black Swan.

White Swans…Black Swans…and the “Grey Swans” in the messy middle. What can investors do?

For starters, we can try to Sherlock our way to an understanding of the key risks out there—but we should expend our greatest energies hunting for consequential risks that few are talking about (mostly our Grey Swans). (If it is popular, it is more likely already reflected in security prices.) There is no surefire path to progress. It helps to start by allowing oneself time to think (independent thinking is rarer than one might presume!) about the state of play from a blank slate, without structure or agenda. But structure and process can also help (tools such as decision checklists and pre-mortem analyses). We could, as just one example, turn our observations on timeless drivers of “Grey Swan” risk into probing questions we force ourselves to confront anew at regular intervals. A few ideas:

Questions that seek to expose subtle sources of portfolio risk

  • Where are we fragile? How can we enhance resiliency?
  • What’s keeping us up at night? Why?
  • What are the most complex parts of our portfolio (assets, strategies, operations)? Do we understand how they work? What could break them?
  • What can we simplify?
  • Can we discover any portfolio or operational risks for which we are not compensated?
  • What’s eating up too much of our time? What has become a distraction from important risks and opportunities? (Avoid “diworsification”.)
  • Are any of our positioning themes based narrowly on predictions of what will happen? (Beware.)
  • Do we feel too content and comfortable in our positioning? (Warning.)
  • Do any of our key views presume investors will act rationally?
  • How can we break the key assumptions and inputs to our risk models?
  • Are all our positions performing well today? (If “yes”, we may be under-diversified.)
  • What factors could break the cross-asset relationships we expect—those we are relying on for diversification? (In investing jargon: what are the conditional correlations and conditional betas we might expect in the risk scenarios that hurt us most?)
  • Are our incentives and motivations aligned with those of our constituents? Is our time horizon the same as theirs? (Beware: your time horizon might not be within your control. Avoid forced decisions.)
  • As the Tao Te Ching suggests, “The mark of a moderate [person] is freedom from her own ideas.” To which ideas do we remain slave? (Note: blind spots can grow worse with age and experience.)

Questions that help us discover underappreciated risks in the economy and markets beyond

  • Does anything big seem to be going on in the world today that just doesn’t make sense or that violates our first principles?
  • What are the most popular narratives out there today? (Try to poke holes. They might be both priced-in and wrong—a toxic combination.)
  • What is important, yet controversial to talk about publicly? (Beware of collective blind spots.)
  • Where are the newest technological innovations being used commercially (i.e., broadly) for the first time? What might go wrong?
  • What is changing at an accelerating rate? (Risk of investor underreaction.)
  • What has changed a lot in a very short time? What or who might have difficulty adjusting?
  • What are investors most complacent about? Where are investors currently seeking safety?
  • What are market participants most worried about? (Such risks are more likely “priced in”.)
  • If we knew nothing about where the economy and markets have been—only where things stand today—would our views and forecasts be different?
  • Are there obvious pockets of overvaluation? Are there obvious “anti-bubbles”?
  • Where might things seem less interconnected than they actually are? What subtle, but critical, linkages can we identify?

Once “detectable” risks are identified—by whichever process—we can bucket them in an actionable way. All risks fall into one of three groups:

  1. Hedge those that i) matter, and ii) can be hedged at a reasonable cost and with high reliability
  2. Diversify those that can be managed “well enough” but can’t or shouldn’t be directly hedged
  3. Tolerate those that cannot be hedged at a reasonable cost or managed effectively—and those that simply don’t matter to us or that we deliberately bear.

Group 1 (“hedge”) risks might include interest-rate risk for a pension fund or currency risk for a sovereign wealth fund deploying capital abroad. These are (comparatively) easy and should be hedged if they are consequential. (Of course, not every risk that hurts us is bad! After all, we need some hurt in our portfolios if we wish to outperform “safe” assets over time.) Many existential deep risks fall into group 3 (“tolerate”) (think: alien invasion), and if there is nothing conceivable that can be done about them, why worry?

Risk events that fall into group 2 (“diversify”) are tricky; these risks tend to coincide with (or cause!) “Bad Times” (a very technical term) for risk assets. They hurt most investors at the same time, so they are expensive to hedge directly (think: equity put options and other forms of explicit insurance that have a negative expected value). And they typically occur infrequently but also unpredictably; directly hedging them requires paying insurance premiums consistently over time, which can overwhelm a portfolio. Making matters worse, both directly and indirectly hedging the full course of a group 2 risk event is far from straightforward because there are so many different “shapes” of risk. Will the event and subsequent recovery follow a “V” pattern? Skinny “V” or wide “V”? Or perhaps a double-dip “W”? What if the post-risk-event regime proves permanent and there is no recovery (“L”). Or maybe the event will unfold slowly at first and then accelerate? (We might soon need a new alphabet or a cursive font!) You get the idea. The shape of a risk event—what it looks like as it unfolds and how long it ultimately lasts—is highly uncertain. It gets harder still: the cost of hedging, directly or indirectly, might change during the event, as (respectively) the cost of insurance or the valuation of diversifying assets rises.

To deal with myriad shapes of risk, we need to find more creative ways to fortify our portfolios: diversifying return streams, unique defensive strategies, and reasonably priced hedges. A thoughtful ensemble might combine long exposure to risk factors beyond pure market “beta” with equity-defensive strategies that, together, have a positive (or at minimum non-negative) expected return over time and an attractive (i.e., negative) conditional beta to global risk assets during major risk events. The key is to strike a reasonable balance between competing objectives: cost (foregone expected return) versus certainty (of a positive payoff when it is most needed). The individual strategies would navigate various shapes of risk differently, diversifying each other and increasing the likelihood that the ensemble does “well enough” over time. Strategy diversification is especially important if we assume—as humility requires—that the next crisis could look like almost anything.

Bottom line

Risk-conscious investing is best described as a mentality. It is the perpetual process of thinking outside the box about the range of possibilities facing economies and markets, hedging crucial risks when we can, and fortifying portfolios against the many risks we cannot foresee. We should: 1) zero in on the risks that hurt us the most; 2) make a careful decision to hedge, diversify, or tolerate each risk (as they say in war, if you defend everything, you defend nothing); 3) expand our toolkit beyond passive risk exposures and strategies as we implement hedges and diversifiers; 4) build in some (positive) convexity to extreme market moves; and most importantly, 5) when in question, prioritize long-term survival (what is the long run, anyway, if not a long string of short runs linked together?). Finally, we should remind ourselves—the time to manage risk is *before* a risk event materializes. (During the event, it is called triage.) “You don’t have time to think up there; if you think, you’re dead.” – Top Gun. There is a common saying in sports: the best defense is good offense. In investing, the opposite may be true: the best offense starts with great defense.

Post-Script: What can we learn from history about risk?

The mundane reality is that we should neither under-rely nor over-rely on history. We do tend to forget the lessons of the past—especially the more distant past—which means we should look deep into history to understand the range of risks that have materialized. A failure to understand the lessons of history is a grave error. (Recall Marie Antoinette, upfront.)

But history tells only part of the story. It can reveal the course of events, but underlying causal relationships often remain hidden from view. And yet making risk assessments about the future requires an understanding of—and a priori reasoning about—these causal relationships. Will and Ariel Durant remind us, in their classic The Lessons of History, that history as written can be quite different from history as lived; the “historian records only the exceptional”. But unexceptional things happen steadily, and they add up over time. (The long march of human progress generally works this way.) Sometimes, the cumulative burden of many unexceptional developments can result in big risks—which, if they never ultimately materialized, won’t be featured in the history books.

Finally, through history, more things could have happened than did happen. The (single) version of history we get is but one of an unimaginable range of outcomes; even the most thoughtful approaches to risk management will fail to contemplate them all. Consider COVID-19: The version of history we got in 2020 just so happened to affect most countries simultaneously, with profound differences across industries (almost perfectly along “old economy” and “new economy” fault lines). But imagine the March 2020 headlines in an alternate history: “Coordinated Cyberattack Cripples Global Cloud Platforms; Digital Systems Remain Down”. What then? Short tech, long restaurants? The future is not knowable, and it is unlearnable from history. “If history books were the key to riches, the Forbes 400 would consist of librarians.” – Warren Buffett. We must study the risks that didn’t materialize as closely as those that did. Ultimately, how much should we rely on history? Just enough.

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About the Author: Matt Tracey

Matt Tracey
Matt Tracey is an investment management professional in New York City. The opinions contained herein are his and not those of his employer and such opinions are subject to change without notice. The information provided here is a summary of Mr. Tracey’s personal experience and is not based on any other parties’ particularized financial situation, or need, and is not intended to be, and should not be construed as, a forecast, research, investment advice or a recommendation for any specific strategy, product or service. Individuals should consult with their own financial advisors to determine the most appropriate allocations for their financial situation, including their investment objectives, time frame, risk tolerance, savings and other investments. The information provided here is not intended as tax advice. Please consult your tax advisor for specific tax questions and concerns.

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