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Mandelbrot Warned Us

October 25, 2008
Warren Boroson

Warren Boroson

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Maybe we should have paid more attention to a somewhat-difficult-to-read book published in 2004.

The book was “The (Mis)Behavior of Markets,” by Benoit Mandelbrot, co-written by Richard L. Hudson (Basic Books).

Mandelbrot’s message: “Like the weather, markets are turbulent. We must learn to recognize that, and better cope.” In other words, investment markets can be more unstable and treacherous than many of us suspect.

Mandelbrot, 83, is Sterling professor of mathematical sciences emeritus at Yale and the creator of “fractal” geometry, which studies the regularities in various irregular systems, from wind tunnels to coastlines.

In his book, he argued that most of the leading financial theories we accept today are badly flawed. Investment markets are not peaceful but turbulent. (Think of the bear markets of 1987, 1997, and 2000.)

Too many people, Mandelbrot argued, believe that the “bell curve” is found everywhere in nature—that most things congregate in the middle, and that the relatively few exceptions peter out on the left and the right. (Hence, the shape of a bell.)

But the bell curve doesn’t apply to the stock market, the cotton market, or to markets in general, Mandelbrot claimed. “The seemingly improbable happens all the time in financial markets,” he wrote. “Extreme price swings are the norm in financial markets—not aberrations that can be ignored.”

Financial advisers may urge Americans to keep 45% of their portfolios in stocks, he went on, but some people are dubious. The Japanese keep barely 8% in stocks, he wrote. Europeans keep 13% in stocks.

So, maybe we Americans shouldn’t have been, and shouldn’t be, as optimistic about stock-market investments as we have been. Remember the book “Stocks for the Long Run,” by Jeremy Siegel, which argued that the stock market was where the big money was to be made?

The trouble with exceedingly turbulent markets, it seems to me, is that (1) we may desperately need money when the markets are in the pits, (2) we may succumb to despair and panic while waiting for the markets to revive—and sell, and (3) it may take a long, long time for such markets to revive.

Lord Keynes put it nicely: Markets can remain irrational longer than we can remain solvent.

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Warren Boroson
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Comments

traderashish
Traderashish - 6 years ago
Financial advisers may urge Americans to keep 45% of their portfolios in stocks,

Very interesting, do people really put 45% or more of their "net worth" in stocks?

Sivaram
Sivaram - 6 years ago
Benoit Mandelbrot and Nassim Taleb have theories that are useful and financial modelers, accountants and risk managers should pay attention (or should have.) However, I would argue that their views are next to useless for investors (certainly not usuful to investors like me who don't use normal distributions to model risk.)

Every investor pretty much knows that the markets are very volatile. Even newbies who have read an investing book with some "history" would know that there are literally crashes, manias, and panics once every 10 years (or even more frequently.) The only ones that seem to be missing the history lesson are the accountants, risk managers, and others who work in the industry. As for investors, I would argue that people speculate and kind of know that they are playing with fire.

You cannot make money with these views. The reason is because everything is close to being unpredictable. You would literally be out of the market for huge stretches--we are talking staying in cash for 8+ years--or you would pursue some lame strategy such as the one suggested by Taleb. If I'm not mistaken, he suggests far out-of-the-money options. My understanding is that his strategies have not made any money for many years, except this year. But I'll bet that it won't make any money for the next 7 or 8 years either (or until another correction occurs.) Overall, I would guess that he would underperform a passive index.
buffetteer17
Buffetteer17 premium member - 6 years ago
"Taleb...suggests far out-of-the-money options."

The point of the options is not to make money, but rather to not lose money.

It was Taleb who gave me the idea of insuring my stock portfolio against disaster with out-of-the-money put options about a year ago. But I didn't buy quite enough of them and I didn't pick the right mix.

With the options, my portfolio return is now at minus 3.6%/year. Without the options it would have been minus 27.4%/year. In addition, the options saved me from margin calls, which would otherwise have forced me to sell undervalued stocks at exactly the wrong time. I have never experienced a margin call, since I could always sell an option contract in case of need. I have in fact sold off about 2/3 of the options so far. My main "problem" is that I'm looking at a rather large tax bill for 2008, because the options profit is all short term and I don't have enough short term losses to offset it.

Without the market crash, the options would have been a drag of about 3%/year on my portfolio return, reducing it from about 30%/year to 27%/year.

If we have a market crash on average every 11 years, the savings of 24% during the crash year would about equal the cumulative loss of 3%/year during the 10 good years. You need a gain of 32% to make up for a loss of 24%.

vooch
Vooch - 6 years ago
> or you would pursue some lame strategy such as the one suggested by Taleb.

> If I'm not mistaken, he suggests far out-of-the-money options. My understanding

> is that his strategies have not made any money for many years, except this year.

> But I'll bet that it won't make any money for the next 7 or 8 years either (or until

> another correction occurs.) Overall, I would guess that he would underperform a

> passive index.

Yeah, but that one big year paid for the next 50 years.

- Vooch

vooch
Vooch - 6 years ago
> or you would pursue some lame strategy such as the one suggested by Taleb.

> If I'm not mistaken, he suggests far out-of-the-money options. My understanding

> is that his strategies have not made any money for many years, except this year.

> But I'll bet that it won't make any money for the next 7 or 8 years either (or until

> another correction occurs.) Overall, I would guess that he would underperform a

> passive index.

Yeah, but that one big year paid for the next 50 years.

- Vooch

vooch
Vooch - 6 years ago
> or you would pursue some lame strategy such as the one suggested by Taleb.

> If I'm not mistaken, he suggests far out-of-the-money options. My understanding

> is that his strategies have not made any money for many years, except this year.

> But I'll bet that it won't make any money for the next 7 or 8 years either (or until

> another correction occurs.) Overall, I would guess that he would underperform a

> passive index.

Yeah, but that one big year paid for the next 50 years.

- Vooch

Sivaram
Sivaram - 6 years ago
Vooch: "Yeah, but that one big year paid for the next 50 years."


I don't follow him closely so I'm not sure if it would have been that good (i.e. probably paid for 5 years more so than 50 years.) The only ones that fit anywhere near your expectation (50 years worth of return in one year) seem to be those that bought CDS. CDS was severely underpriced and there are many who made billions (William Ackman, Prem Watsa, John Paulson, etc.) I'm not sure if options would have been that good of a bet.


In any case, even if it paid for 50 years, it's pure gambling. Nothing more, nothing less. You will be paying a price for every year it doesn't work out. You are basically betting on a very low probability event. It's like continuously betting on the hope of getting a Royal Flush in poker. Those making the low probability bets on the stock market would argue that they are confident of their call. But then again, so are all those gamblers betting on low probability poker hands, or underdog horses, and so forth.

Or if you diversify by following Taleb's suggestion (admittedly this is just one of his many suggestions) of holding the vast majority (90%) in cash with a small amount in low-probability bets, the returns don't seem that great. You can plug in your estimates but Roger Nusbaum's numbers yield around 9.5% per year. He says it has lower volatility than the market but there are a lot of if's and but's.

Anyway, I'm not dissing these guys in general. Like I said, their thinking is useful for risk managers and the like. But these are some terrible investing strategies. It looks good right now because people are very short-term oriented and looking at the recent collapse. There is a reason you only hear about these strategies AFTER a collapse. Five years from now, you probably wouldn't even hear about any of this.
Sivaram
Sivaram - 6 years ago
Buffetteer17, thanks for the detailed post. I'm skeptical of these set of strategies (they are many, not just one.) One of the problems with your situation is that you use leverage. Furthermore, we need to look at a much longer period of time. Obviously the strategy looks good because the low probability event materialized sooner rather than later. If I run across some detailed analysis, I'll try to post it.
vooch
Vooch - 6 years ago
Sivaram,

The point is the low probability events were mispriced.

Last year, I bought S&P500 puts for 75 cents. They shot up to $48, maybe more.

Unfortunately, I only made a +100% profit, but it taught me the scale and limits of these low probability bets.

- Vooch

buffetteer17
Buffetteer17 premium member - 6 years ago
Taleb stated that he made 97% of all the investment gains he ever made in the 1987 market crash. What he profited from was--you guessed it--out of the money put options. That amounted to some 10s of millions of dollars. After that, all he wanted to do is preserve capital. So for him, going 90% plus into short term treasuries makes sense. With $30-40 million in the bank, I'd do likewise.
buffetteer17
Buffetteer17 premium member - 6 years ago
What if I had sworn of margin debt in Oct. 2007, rather than buying the hedge?

I calculated what my portfolio return would have been had I completely paid of my margin loan and gone to 10% cash last October 26, 2007. This is assuming that I had held, bought, and sold the same stocks at the same times, just proportionately less. That would have been about 38% less money invested. I want to compare that scenario to how I did with about 28% (starting) margin debt plus the hedge.

The portfolio return worked out to about -17%/year. With the margin debt plus hedge, my return is currently about -4%/year.

So I'm doing about 13% better the way I played it. That surprised me, I had thought I would have been better off just to swear of the use of margin debt a year ago. You could say it was luck and I wouldn't disagree. I had no idea we were on the verge of the worst bear market in a generation. But I wouldn't have had that luck had I not acted, so I deserve some credit.
DaveinHackensack
DaveinHackensack - 6 years ago
Buffetteer17 has probably outperformed all of the Gurus on this site this year because of his hedges. I wish I had done something similar. Incidentally, there is a mutual fund manager who hedged his fund as well, John Hussman, Ph.D., of Hussman Funds. Maybe he and Buffetteer17 should be added as Gurus to this site.

Sivaram,

You may find Hussman's weekly commentary of interest, because he gives some insight into how and when he hedges. He is both an economist and a mutual fund manager, so his commentary is informed by practice, and not just academic theory.
DaveinHackensack
DaveinHackensack - 6 years ago
Incidentally, for those of you could use a lift, here's a song about Benoit Mandelbrot by Jonathan Coulton, "Mandelbrot Set"

vooch
Vooch - 6 years ago
buffetteer17,

> The portfolio return worked out to about -17%/year. With the margin

> debt plus hedge, my return is currently about -4%/year.

That's great considering the S&P500 is down -43.49% for the past 12 months. You did an awesome job of buying those puts in October 2007 and holding them! I wish I held mine. I'm down about -17.44% for the past 12 months. That's why I love Value Investing so much.

- Vooch

epicahab
Epicahab - 6 years ago
There was a PBS Nova about Mandlebrot this week...awesome stuff.

I'm trying to follow the discussion of options. I definitely understand what buffetteer is saying about having to make back losses, but is it really the best strategy to buy insurance to avoid short term losses? It seems like this obsession with the short term should only apply to those near retirement who can't wait it out.
buffetteer17
Buffetteer17 premium member - 6 years ago
I'm near retirement. Expect to retire next year.
DaveinHackensack
DaveinHackensack - 6 years ago
"I definitely understand what buffetteer is saying about having to make back losses, but is it really the best strategy to buy insurance to avoid short term losses?"

It depends on the size of the loss. It's worth quoting John Hussman here, from his most recent market commentary:

...[I]t is important to contemplate the possibility of unexpected market outcomes, by avoiding investment positions that have a risk of intolerable losses if prices move against us.

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even. A fully invested position in the S&P 500 has already experienced what I view as an intolerable loss, because the 43% loss from the high now requires a 75% gain just to break even. In contrast, a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally). As for the Strategic Growth Fund, we've experienced a 13.9% decline from the record high set a few weeks ago, which is uncomfortable, but can be reversed relatively easily.


Note that neither Hussman nor Buffetteer17 have hedged themselves to the point where they avoid any short-term loss -- that sort of insurance would probably be too expensive to be worthwhile -- but they have hedged themselves sufficiently to avoid what Hussman calls "intolerable" losses.

epicahab
Epicahab - 6 years ago
buffetteer17 Wrote:

-------------------------------------------------------

> I'm near retirement. Expect to retire next year.


Well that answers that! I wish you a successful retirement.

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