The Risk-Return Trade-Off Is Phony

Conventional wisdom in investing says there’s a trade-off between risk and return. To make a lot of money, you must take the chance of big losses. Play it safe and you’ll most likely have to settle for meager returns.

The investor Mark Spitznagel says that reducing risk actually increases returns, and he has evidence. He is the founder and chief investment officer of the Miami-based hedge fund Universa Investments LP, where Nassim Nicholas Taleb, the best-selling author of “The Black Swan” and other books, holds the title of distinguished scientific adviser.

Spitznagel writes in his new book, “Safe Haven: Investing for Financial Storms,” that “Universa’s risk-mitigated portfolios have, over their decade-plus life to date, outperformed the S&P 500 by over 3 percent on an annualized, net basis.” (I trust his numbers since Universa would be killed by the Securities and Exchange Commission if he made stuff up.)

Here’s the zinger: “This performance is a direct consequence of having far less risk,” Spitznagel writes.

I spoke with Spitznagel at length about his book. He is a nice, smart guy as well as a farmer: He owns a spread in Northport, Mich., that raises goats to make cheese. But I have no interest in promoting Universa — and I certainly don’t need to feed the ego of Taleb, who openly disdains journalists.

The reason for writing about safe-haven investing is that I think Universa is on to something that the rest of the industry should heed.

The basic idea is simple: Survival is essential. If a portfolio does well on average but by bad luck has a series of big losses, it may never be able to recover. So it’s essential to protect against losing a lot of money in any one period. And don’t count on the passage of time to rescue it: If a portfolio isn’t well insured, the risk of blowing up and losing everything goes up over time, not down. The wealth accumulated in the long run will be greater if the emphasis is on insuring against big losses, even though doing so incurs a cost.

The funny thing about that is it’s counterintuitive to anyone who studied Modern Portfolio Theory, a business school staple, but makes perfect sense to ordinary people who are accustomed to protecting themselves against big risks in their daily lives.

The math is interesting. Consider the difference between 300 people each rolling a six-sided die once and one person rolling the die 300 times in a row. Modern Portfolio Theory implicitly assumes that the outcome would be the same, but it’s not, as Spitznagel describes with examples.

Let’s say the payoff from rolling a one is minus 50 percent, the payoff from rolling a six is plus 50 percent, and the payoff from the other four sides is plus 5 percent. The average return for the 300 people who roll once each would be 3.3 percent — not bad for a moment’s work. Things are likely to turn out far worse for the poor person who rolls 300 times. Now those ones with their negative payoffs are like land mines. The compound growth rate here will be around negative 1.5 percent, and after 300 rolls the starting stake of $1 will most likely be down to a mere penny. A person who played that game and by chance never rolled a one would make a killing, but it’s probably not going to be you.

As an investor, you’re not the 300 people rolling once each. You’re more like the lone person rolling again and again, repeatedly exposing yourself to the chance of a big loss. A post on the Flirting with Models blog stated it well: “If we have our arm mauled off by a lion on the African veldt, we cannot simply ‘average’ our experience with others in the tribe and end up with 97 percent of an arm.”

Modern Portfolio Theory’s prescription for reducing risk is diversification — not putting all your eggs in one basket. That does reduce volatility because the ups and downs of individual holdings tend to occur at different times and balance one another out. But it still leaves you exposed to the ups and downs of the overall market while dragging down performance. Spitznagel borrows a phrase from the famed investor Peter Lynch, who calls diversification “diworsification.”

Spitznagel’s alternative is insurance. In his funds he shaves off a small portion of the portfolio — 3 percent or so, depending on circumstances — and puts it into an asset that isn’t expected to make any money on average but will go up a lot when everything else goes down. In my interview, he declined to discuss the nature of this insurance, but put options would be one natural choice. (A put option gives its holder the right to sell an asset such as a stock index futures contract to a counterparty for a set price. The option becomes valuable when the market price of the asset falls below the strike price of the option.)

Some Universa wannabes load up on this kind of insurance, but that gets expensive because most of the time the market or asset doesn’t crash and those options expire worthless. Universa’s secret sauce is how to buy “sufficient bang for the buck” to offset losses when things go south, Spitznagel says. In the book, he calls this “cost-effective risk mitigation.”

Neither Spitznagel nor Taleb discovered this stuff, which goes by the clunky name of non-ergodicity. The original insight goes back to Daniel Bernoulli, an 18th-century Swiss mathematician. It wasn’t until the 20th century that it was widely embraced by physicists and mathematicians, including Claude Shannon of Bell Laboratories, the father of information theory. Henry Latané of the University of North Carolina applied the idea of non-ergodicity to finance. More recently the cause of non-ergodicity has been taken up by the likes of the Santa Fe Institute in New Mexico and Alex Adamou and Ole Peters at the London Mathematical Laboratory.

In 2005, I reviewed a wonderful book by William Poundstone called “Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street.” It tells the story of a young Texan physicist named John L. Kelly Jr. who used Shannon’s insights to devise a betting system that prescribes how much of your bankroll to put on any given bet to make money while insuring against ever going bust. This is known today as the Kelly criterion. Spitznagel told me he uses a version of the Kelly criterion, tailored to the needs of investors rather than gamblers.

I asked Spitznagel what his latest book contributes, since Taleb, and others, have written hundreds of pages on and around the topic already and Spitznagel himself touched on it in an earlier work, “The Dao of Capital.” He said it explains “the real costs and benefits of risk mitigation” and sends a message to the hedge fund industry, which he views as guilty of the “diworsification” prescribed by Modern Portfolio Theory. Any hedge fund or other investor that focuses on “risk-adjusted return” has its head screwed on wrong, Spitznagel says. “Hedge fund managers shouldn’t be reading this book and nodding their heads in agreement,” he says. He says he does admire the investor Warren Buffett, who he says focuses correctly on his investments’ compounded rate of return.

Spitznagel said he can’t give advice to ordinary investors because that would depend on people’s particular circumstances. He did say that while he believes in stocks for the long run, he wouldn’t advise people who have been out of the market to jump in now, especially if they have a short time horizon, because he thinks stocks are overpriced. While he rails against “diworsification,” he said he wouldn’t fault risk-averse investors for spreading their bets, say, in a typical mix of 60 percent stocks and 40 percent bonds.

“My goal is to raise wealth over time, he said. “If that ceases to be the goal, if people just don’t want to lose money, then invest accordingly. As long as you know it comes at a cost.”

Number of the week

1.9 percent

That’s the seasonally adjusted growth in U.S. retail sales from September to October, according to the estimate of economists at Credit Suisse. It’s higher than the median economist estimate of 0.8 percent. Inflation accounts for a lot of the increase, Credit Suisse says. Stripping out price effects, Credit Suisse looks for “still solid” monthly growth of 1.1 percent in inflation-adjusted retail sales. The official number will be reported by the Census Bureau tomorrow.

Quote of the day

“Net worth tripled between 2000 and 2020 to $510 trillion, or 6.1 times global G.D.P., with China accounting for one-third of global growth.”

— McKinsey Global Institute, “The rise and rise of the global balance sheet: How productively are we using our wealth?” Nov. 15, 2021

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