Safe haven by Mark Spitznagel

Try imagining a place where it’s always safe and warm
“Come in,” she said, “I’ll give you shelter from the storm”

I bought Safe Haven by hedgie Mark Spitznagel from a recommendation in one of Monevator’s comments. I’d agree with the comment that the book doesn’t leave you with anything actionable, but perhaps as Dion Fortune said of the Cosmic Doctrine, the object is to train the mind, not inform it. This Spitznagel achieves IMO. It isn’t a long book, I read it in a couple of hours in one sitting, albeit punctuated by watching a movie with Mrs Ermine.

Reading has its systole and diastole, which is why cramming is tough, which is why doing something else midway lets you digest it better – Darwin was a fan of walking for this purpose. I only find that useful for when I originate something creative, but the movie improved the digestion of the book’s 240 pages, presumably by letting something in the background reflect.

Spiznagel is pretty full-on, a reasonable storyteller, and uses metaphor and analogy well. The main takeaway is that many of us  evaluate investment prospects by expected value. Despite the standard FSCS warning that past performance is not a guarantee of future results, that’s sort of what happens. The author disses macro investing, and goes on to make the assertion that managing (tail) risk can be cost-effective. In particular, that it can improve your compound annual growth rate (CAGR) without costing you performance

cost‐effective risk mitigation—or raising compound growth rates and thus wealth through lower risk—is really our comprehensive goal as investors.

Spitznagel, spends the rest of his book showing you how you can recognise an asset class that could do that.

Tragically for you and I, dear reader, that asset class isn’t something that you or I could go out and buy, or synthesise from something we can. It might be possibly in the hedgie world. I am somewhat glad that intuitively I found one of the few assets that sort of comes close-ish. The book also has value in showing that you can compute the optimal amount of that asset class.

Yes, there really is a buried treasure for investors, one that solves our monumental problem by showing that the great dilemma of risk—the ostensible tradeoff between higher returns and lower risk—is actually a false choice. […] We need a more holistic approach; we also need a treasure map to know where to dig.

But just because that buried treasure exists doesn’t mean we will ever find it. The greatest value—more than in the treasure itself—will be in what we gain from the hunt.

I was tempted to issue a refund request, having gotten to the end and being told that the ideal was a chimera, for civilians at least, and since less than 24 hours had elapsed between buying it I would have got away with it.  Amazon track how much of a Kindle book you have read, though I don’t have a habit to returning Kindle books so I’d probably be OK.

But after sleeping on it I came to the conclusion that I did learn something, but in a Dion Fortune like way. My mind was trained, not informed. Most non-fiction reading is to inform the mind. So I got my £15 worth, but it wasn’t the £15-worth I expected.

Spitznagel insights – training the mind, not informing it

Take the Saint Petersburg dice game, a single roll of the dice offers

Wotcha going to pay to play this game? The expected value is ($1+$2+$6+$22+$200+$100000)/6=166,705

but I am guessing most people wouldn’t pay that much, intuitively. It seems obvious that with five chances of being largely wiped out you wouldn’t pay the expected value. Bernoulli’s computation shows if you compute the geometric mean of what you end up with, you can estimate what a reasonable proportion of your total wealth you would pay for this wager. If you had £100,000 then paying about £37k or less to take part gives you a better than even chance of ending up better off. It quantifies the fact that you can take more risk if you have more capital that you don’t immediately need.

Reading the methodology gives an analytical solution to the gut feel approach, and is intriguing. However, the training not informing shows, because most risks you take give a return proportional to amount you put in. However, Spitz has only got started at this point, and he uses a sequence of returns that includes a catastrophic loss (to 0%) to show that where you have a sequence of returns that build on each other then risk mitigation can be worth while,

The arithmetic cost of its risk mitigation is more than offset by its geometric effect—such that its net portfolio effect is positive.

Most of us invest in a single lifetime of a specific sequence of returns. I still remember hearing my German great-grandmother describing sequence of returns risk – they lost their (financial) life savings twice. Fortunately most Anglosphere stock drawdowns aren’t that extreme, but Spitznagels view on central bank meddling suggests that this is not an immutable law of nature, particularly in a declining Imperium.

The Spitznagel edge

Spitznagel despises modern portfolio theory, which is the rough assumption that you buy a mix of less volatile but lower-returning assets like bonds and more volatile but higher returning assets like equities. Inherently in that mix is the takeaway that you will give up some return, and Spitz has no time for such milquetoast ambition.

However, to this mustelid reader he spends a lot of his book in search of something that you could replace bonds with, bonds being the most common MPT risk mitigator of choice¹.

As one example, say at the beginning of the ISA year I could save that £20k in an ISA, less an amount that I could go to an insurance firm and say here is £x. If this time next year the market falls more than y%, pay me some lump sum proportional to x (but note NOT proportional to the fall, this is a cliff-edge function and therefore non-linear).

He spends a fair amount of time showing how you would compute the right amount to spend on this insurance, and in his examples it’s not very much. I haven’t given enough thought to whether you can do this with options and CFDs, but I don’t know of anywhere you can go to buy this sort of thing.

You can spreadbet against losses, but in general it is always cheaper to simply buy less of the asset and sit on cash. I have spreadbetted against my ISA in times of market turmoil, but that’s not the same as doing this steady state, which is an exercise in futility.

However, to return to the training the mind aspects, one of his key statements is

We experience profits and losses and all accounting ledgers arithmetically; we experience life arithmetically—one thing after another. This is linear thinking versus geometric thinking. It’s a big difference and essential to our understanding of risk and the disastrous impact of losses on wealth. But it is highly counterintuitive. Here you face an inconvenient, uncomfortable but crucial truth:

Your raw, linear returns are a lie; your true returns are crooked.

Bernoulli’s call to map returns through the logarithmic function was thus a normative one, not a positive one. In basing decisions on the geometric average of expected wealth or returns, not on the arithmetic average, Bernoulli was showing us how we should view risk—not how we necessarily do view risk. And this is precisely where economists got it so wrong.

I find this reasonably compelling. It’s not totally new to me but this exposition is good. I have no idea of if economists got this wrong, but we generally experience a particular sequence of risk. In both the housing market and in the dotcom bust I experienced that the crawl back from a double-digit loss is long and slow, and best made up by Saving More than trying to make it back in that market. If you lose 50% you have to make a 100% profit on what you have left to get back to where you were before.

Some of this you can lean against by not being 100% invested in equities – you reduce your arithmetic return natch, as you are less exposed to the equity market. But you improve your geometric return, because you live to fight another day. Spitz gives you the lowdown in the bit on the Kelly ratio, but again, what makes that less actionable for most is that having seen the value of your equity holdings go titsup in the markets you need to get right back on the horse and throw some of your cash into that now undervalued market. Easy to say, not so easy to do. That’s why people have bonds, and I have gold.  I don’t do bonds, because I estimate 25 times my net DB pension as a bondholding, and unless I get a fair bit older I can’t manage the right mix.

Theory would therefore point me in the direction of 100% equities. But I have had a pretty decent run, I don’t need to shoot for the lights, and sometimes comfort is more valuable than performance. So while Spitznagel wouldn’t approve, I take a lower expected return, because I can.

The big killer is there is no safe haven for little people

Spitznagel has turned the handle on all the things people typically regard as safe havens and qualified them against his specific criteria of cost-effective safe havens (ie they get your CAGR above the 95% confidence interval  of the S&P over a representative set of trial periods)

And the results are in. Little people, you are hosed. As it happens an Ermine does use gold (and there is a useful piece of the Spitz in how you qualify how much gold you should hold, about 20% is right for me)  But before you all rush out to buy SGLP, most of the trial periods where gold lifted itself into Spitznagel success territory happened to be in the 1970s, after Nixon repudiated the convertibility of the dollar into gold at a fixed rate. So gold may not be all that after all.

“Gold is pretty darn good. You just have to understand there’s been a lot of noise around it.” – underlining gold’s value as a safe haven, while noting that it performs best when inflation expectations are high, and historically it’s been inconsistent in mitigating portfolio risk.

Obviously if you can buy insurance on Spitznagel’s terms then you are off to the races. But those terms are tough –

Any punter can devise a trade that does well in a crash. The key is how do you do in a crash relative to the rest of time.

Yeah, quite. From his Yahoo Finance interview via Business Insider interview

“The Federal Reserve is manipulating the most important information parameter in the economy, and that’s the interest rates.”

“I have this expectation of destruction in the financial markets. That doesn’t necessarily mean that someone should just hide away, because that may not be the best strategy either.”

Where’s Clint when you need him, eh? Do you feel lucky, punk?

Spitznagel’s Universa Investments hedge fund returned 4,144% in the first quarter of 2020

An Ermine felt pleased to get out of the first quarter of 2020 with the black tip to my tail intact after selling some crap and shorting some of my ISA. DNFS – bollocks to that. Going for a 40-bagger, now  that’s ambition.

More Spitznagel

Spitznagel’s company Universa

Spitznagel on the FT (Oct 20 this year)

“It would be very hard for bonds going forward to provide cost effectiveness. Bonds really represent the canonical case of the mean-variance approach of lowering the volatility in a portfolio, but being poorer because of it.”

Finally

No book is ever gonna tell you what to do successfully as an investor.

Well, this one sure ain’t. There’s a lot of good stuff in there, and I am sure I have brutalised the principles from a mixture of a lack of comprehension, not being as smart as Spitzy-boy and the exigencies of making it into a post. Nevertheless, it will probably reward re-reading, though I am almost 100% sure that it won’t give me anything actionable. Training the mind, not informing it…

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1. TIPS is the archetypal risk-free asset class – risk-free, that is, if you believe the CPI inflation index used by the Fed, which is a different matter. ↩