deworsification?

Let's start here...

Essential Wisdom from Twenty Personal Investing Classics (6 min read)

Elm Wealth distills investing lessons from 20 classics, cross-referencing them with James J. Choi’s paper Popular Personal Financial Advice versus the Professors (Journal of Economic Perspectives, Vol. 36 No. 4) that analyzed advice across 50 best-selling personal-finance books, revealing where popular wisdom aligns (or clashes!) with financial theory.

This stood out to me:

Bear in mind that the first twelve books listed above are written for the broad audience of all investors in developed market economies, with particular focus on US investors. It is well-known (and disturbing) that the financial literacy of this audience is, on average, quite low – as evidenced by a mean score of 56% (yes, that would be an “F” if not graded on a curve) on the below five-question quiz, known as the “Big Five” test by researchers. A survey conducted in 2021 found that less than one third of respondents answered at least four of them correctly, the threshold researchers define as “high financial literacy.” At least as concerning as the low test scores is the fact that the scores themselves have fallen dramatically between 2009 and 2021. If you decide to read some of these books, don’t be surprised to find a good deal of the advice proffered seems blindingly obvious if you come to them with above-average financial sophistication.

Umm, the quiz:

With the growing zoo of money distractions (crypto, gambling, prediction markets) and the results on that quiz, I’m guessing a large swath of society is gonna feel like there’s a financial tapeworm in their wallets.

I tweeted this a few days ago:

Let’s focus on evergreen financial hygeine. These were common themes I saw in the books Elm Wealth selected:

• Diversify. It’s the rare free lunch: combine two assets with equal expected return and volatility, and your portfolio’s risk-reward improves.
• Minimize frictions. Avoid fees, taxes, and excessive trading.
• Reduce touchpoints. The fewer chances to act on emotion, the better your long-term results

Just to piggyback on the diversification bit. It sounds trite, but you’ll hear some people push back against it with the buzzword “deworsification”. When you’re as smart as Warren Buffett maybe you can use this word. But Buffet himself recognized Ed Thorp was a genius despite Thorp’s strong conviction in diversification. [And vice versa, by the way. Thorp’s recollection of hanging out with Buffet when they met in their 30s is pretty heart-warming. Game recognizing game. Apparently, after dinner Buffet showed Thorp a toy he really liked — non-transitive dice. Think of them like roshambo. A beats B which beats C which beats A.]

Here’s the cold-ass truth. Not diversifying is incinerating money. Looking back at your concentrated outcome and saying “see” is not proof of anything but survivorship. In fact, you can prove mathematically that diversifying is a free lunch.

What would you rather own?

Portfolio A: a single stock with an expected return of 10% and 30% vol

OR

Portfolio B: an equal-weight portfolio of 2 stocks where each has 10% expected return and 30% vol but are 70% correlated

Stuff you can read if this is not clear:

• You Don’t See The Whole Picture
• Your Portfolio Intuition Is Poor
• Why You Don’t Get Paid For Diversifiable Risks
• Is There Actually An Equity Premium Puzzle?
• DCF As A Lower Bound

The proof is sitting there in market prices too. A diversified portfolio of inferior credits will have a higher rating than the bonds in the basket. A higher rating means a higher price (lower yield).

The nuances of that are better understood today than they were in the heyday of CDO-squared.

See the GFC through a quant’s eyes

Of course, diversification always means you left something on the table in hindsight. You sign up for FOMO. But this is the nature of every decision. If you get crushed, you wished you traded zero and if you win, you wish you traded more. Results alone tell you nothing about the quality of your shot.

To complete the point:

“If you invest and don’t diversify, you’re literally throwing out money,” stated Jeff Yass. “People don’t realize that diversification is beneficial even if it reduces your return.”

Why is this the case? “Because it reduces your risk even more,” added Yass. “Therefore, if you diversify and then use margin to increase your leverage to a risk level equivalent to that of a nondiversified position, your return will probably be greater.”

The modern pod shops are another triumph of diversification, which takes us to the next section…

I am impressed by the multi-managers on the whole. They continue to generate positive returns with outstanding Sharpe ratios and thus far don’t capture the same downside as conventional 60/40 portfolios.

I think of them as the holy grail marriage of deep security research that you would have associated with a long/short fundamental manager plus the quantitative risk management and attribution metis that prop trading firms trading their own money have accumulated through the decades.

Many investors, usually from the cheap seats, want to hate on them because they don’t match the SP500 plus their pass-through fees are multiples of typical fees. Not to mention, hedge fund managers are just natural villains to normal people who maintain a Richard Scarry worldview about which jobs are valuable (eh, like any competitive profession, some of them are decent and some of them are vampires).

Regardless, this quote from Byrne Hobart conveyed something I never found the words for, so as soon as I read it, I had to clip it.

From Why Does Volatility Matter?:

If the portfolio you’re looking at is 100% net long conventional asset classes, and if you think it’s absurd to pay high fees in order to match the S&P with less liquidity—lucky you! You’re part of society’s financial shock absorber, a middle class or above saver in a rich country with functioning capital markets. But if you’re in that position, there’s a very real sense in which joking about how the S&P has outperformed complicated multi-manager setups year-to-date is a form of financial punching-down. They have a different benchmark, and a harder job. And they’re doing you the very generous service of ensuring that the next time you buy the S&P 500, the price of every single component reflects the collective attempt by thousands of professionals with massive data and analytics budgets who are all trying to push the price 1% closer to optimal.

I want to share another post from Andrew who I introduced last week.

So-Called “Bonds” in Prediction Markets

Great subtitle:

Rare events teach slowly