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What A Nobel Laureate Can Teach Us About Trading
Almost anyone who trades knows about the Sharpe ratio. It’s a measure of risk earned in excess of the risk-free rate per unit of volatility. The formula basically tries to answer the question -- how much risk did you assume in order to achieve that return. Now in our YOLO world where only the end result matters, one might ask -- who cares? Nevertheless, the Sharpe ratio is a useful tool to see if basically, you are one trade away from total ruin and every single money manager and trader on Wall Street must submit to its measurement before having any capital allocated to them.
The man who invented the Sharpe ratio, William Sharpe, is a Nobel prize-winning economist who is now retired, but he has not stopped putting his creative mind to solving investment problems. His latest project is what he calls the ‘Nastiest, Hardest Problem’ in Retirement, namely, how do you make sure your money will last your lifetime.
We live at an interesting time in history where the human lifespan in the OECD world has been extended by 150% while working years have basically remained static. This has created what in finance is known as a liability mismatch. Retirement assets are simply not elastic enough to sustain the new longevity The problem is massively aggravated by the volatility of equity returns. Imagine you’ve been investing diligently for 10 years and have built up a nice portfolio of 1M dollars off a total capital contribution of $500,000. Then in a span of 3 months, all those profits disappear and your original stake is now worth only $400,000. Ten years of wealth-building down the drain in less than a quarter. That’s what happened to investors in 2008.
Of course with the benefit of hindsight, we know that the markets not only recovered but doubled but many people -- in fact, most likely the majority -- panicked and sold at the bottom and then took years to get back into the markets. It’s easy to say that investors should hold through thick and thin, but as we know from trading nobody ever does. We all sell out at the bottom. At that moment no one is thinking about compounded returns 20 years forward. We are all trying not to become homeless tomorrow.
This is the precise problem that William Sharpe has tried to tackle and he has come up with a rather elegant solution to help investors protect themselves from their worst instincts. As he tells Barrons, “The idea is that you segment your money. It’s similar to using “buckets” but with a time component. A retiree might have a box for 2020 and a box for 2021, and 2022, etc.
In each box, you have a combination of safe assets, such as an annuity or TIPS [Treasury inflation-protected securities], and a market-based portfolio, such as one with stocks and bonds. You have the key if you need to access the funds, but the idea is that, once a year, you would sell the assets in that year’s lockbox. You put all your money in locked boxes, to begin with, and you just happily open locked boxes. If you’re dead, your partner opens the lockbox, and if you’re both dead, your estate opens all the lockboxes that are left.”
Why is this better than just putting all your money into a single account stream? Two reasons. One is financial. By creating short term lockboxes that are essentially made up annuities, zero-coupon bonds, and TIPS, you assure yourself that you have the income stream to survive for the immediate future while allowing “long-tern” lockboxes remain in the equity market where the volatility does not affect your short term needs. The other reason is of course physiological. The math is the same in both scenarios. You only have so much money and it can only compound in a certain way given the performance of the assets. BUT! your ability to weather the market storm is much more durable if you were confident that your income streams were assured for the near term.
Sharpe’s segmentation idea really resonated with me because I have already been exploring it with my own trading account. Lately, I segmented my trading capital into various strategy “buckets” with a wide variety of lever and instrument factors. The results have been very promising. For the first time in my life, I have let strategies run without interference and they are really starting to perform.
Ever have a day when one bad trade tripped you up? And then you started to revenge trade and then the whole account got annihilated over what was supposed to be a 0.5% risk? This is exactly the problem that segmentation tries to cure. Because the true risk to our capital isn’t one bad trade, but what we do afterward. If you had no more money in your segmented account to revenge trade the damage would be contained.
Segmenting your capital by strategy, instrument and lever factor also has optionality embedded into the process. Let’s imagine you are a venture capitalist but instead of companies, you stake 10 different strategies in 10 different accounts. Now some -- perhaps most -- will blow up or lose 50% of value over time especially if you use even a mild lever factor. But one or two may be totally in sync with the current market environment and go on a massive tear tripling or quintupling their value. That’s all you need to be overall profitable -- but if you have all your assets in one account you will never have the mental strength to let the winning strategies run because you will be constantly looking at the P/L of the account and taking small profits to offset the big losses.
My example doesn’t even have to be that dramatic. You could just have most strategies tread water (which is what happens in real life, at least with me) while one or two make all the money. The Pareto Principle never goes away in life. William Sharpe’s great insight is to simply harness its value for all of us.