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- Successful investing requires that investors navigate around a large number of risks throughout their lifecycle. We believe that the two most daunting risks investors face are the risk of failing fast and the risk of failing slow.
- Slow failure occurs when an investor does not grow their investment capital sufficiently over time to meet future real liabilities. This often occurs because they fail to save enough or because they invest too conservatively.
- Fast failure occurs when an investor – often those who are living off of portfolio withdrawals and for whom time is no longer an ally – suffers a significant drawdown that permanently impairs their portfolio.
- We believe that sensitivity to these risks should dictate an investor’s allocation profile. Investors sensitive to slow failure should invest more aggressively and bear more risk in certain bad states of the world for the potential to earn excess returns in good states. On the other hand, investors sensitive to fast failure should invest more conservatively, sacrificing returns in order to avoid catastrophe.
- We believe this framework can also be used to inform how investors can fund an allocation from their strategic policy to trend equity strategies.
Homer’s Odyssey follows the epic ten-year journey of Odysseus and his men as they try to make their way home after the fall of Troy. Along the way, the soldiers faced a seemingly endless string of challenges, including a cyclops who ate them alive, a sorceress who turned them into pigs, and sirens that would have lured them to their deaths with a song had they not plugged their ears with beeswax.
In one trial, the men had to navigate the Strait of Messina between the sea monsters Scylla and Charybdis. With her six serpentine heads, each with a triple row of sharp teeth, Scylla haunted the cliffs that lined one edge of the strait. Ships that came too close would immediately lose six sailors to the ravenous monster. Living under a rock on the other side of the strait was Charybdis. A few times a day, this monster would swallow up large amounts of water and belch it out, creating whirlpools that could sink an entire ship.
The strait was so narrow that the monsters lived within an arrow’s range of one another. To safely avoid one creature meant almost necessarily venturing too close to the other. On the one hand was almost certain, but limited, loss; on the other, the low probability of complete catastrophe.
Investors, similarly, must navigate between two risks: what we have called in the past the risks of failing slow and failing fast.
Slow failure results from taking too little risk, often from investors allocating too conservatively or holding excessive cash. In doing so, they fail to grow their capital at a sufficient rate to meet future real liabilities. Failure in this arena does not show up as a large portfolio drawdown: it creeps into the portfolio over time through opportunity cost or the slow erosion of purchasing power.
Fast failure results from the opposite scenario: taking too much risk. By allocating too aggressively (either to highly skewed or highly volatile investments), investors might incur material losses in their portfolios at a time when they cannot afford to do so.
We would argue that much of portfolio design is centered around figuring out which risk an investor is most sensitive to at a given point in their lifecycle and adjusting the portfolio accordingly.
Younger investors, for example, often have significant human capital (i.e. future earning potential) but very little investment capital. Sudden and large losses in their portfolios, therefore, are often immaterial in the long run, as both time and savings are on their side. Investing too conservatively at this stage in life can rely too heavily on savings and fail to exploit the compounding potential of time.
Therefore, younger, growth-oriented investors should be willing to bear the risk of failing fast to avoid the risk of failing slow. In fact, we would argue that it is the willingness to bear the risk of failing fast that allows these investors to potentially earn a premium in the first place. No pain, no premium.
Over time, investors turn their human capital into investment capital through savings and investment. At retirement, investors believe that their future liabilities are sufficiently funded, and so give-up gainful employment to live off of their savings and investments. In other words, the sensitivity to slow failure has significantly declined.
However, with less time for the potential benefits of compounding and no plan on replenishing investments through further savings, the sensitivity to the risk of fast failure is dramatically heightened, especially in the years just prior to and just after retirement. This is further complicated by the fact that withdrawals from the portfolio can heighten the impact of sustained and large drawdowns.
Thus, older investors tend shift from riskier stocks to safer bonds, offloading their fast failure risk to those willing to bear it. Yet we should be hesitant to de-risk entirely; we must also acknowledge longevity risk. Too conservative a profile may also lead to disaster if an investor outlives their nest-egg.
As we balance the scales of failing fast and slow, we can see why trying to invest a perpetual endowment is so difficult. Consistent withdrawals invite the risk of failing fast while the perpetual nature invites the risk of failing slow. A narrow strait to navigate between Scylla and Charybdis, indeed!
We would be remiss if we did not acknowledge that short-term, high quality bonds are not a panacea for fail fast risk. Inflation complicates the calculus and unexpected bouts of inflation (e.g. the U.S. in the 1970s) or hyper-inflation (e.g. Brazil in the 1980s, Peru from 1988-1991, or present-day Venezuela) can cause significant, if not catastrophic, declines in real purchasing power if enough investment risk is not borne.
Purchasing seemingly more volatile assets may actually be a hedge here. For example, real estate, when marked-to-market, may exhibit significant relative swings in value over time. However, as housing frequently represents one the largest real liabilities an investor faces, purchase of a primary residence can lock in the real cost of the asset and provide significant physical utility. Investors can further reduce inflation risk by financing the purchase with a modest amount of debt, a liability which will decline in real value with unexpected positive inflation shocks.
The aforementioned nuances notwithstanding, this broad line of thinking invites some interesting guidance regarding portfolio construction.
Investors sensitive to fast failure should seek to immunize their real future liabilities (e.g. via insurance, real asset purchases, cash-flow matching, structured products, et cetera). As they survey the infinite potential of future market states, they should be willing to give up returns in all states to avoid significant failure in any given one of them.
Investors sensitive to slow failure should seek to bear a diversified set of risk premia (e.g. equity risk premium, bond risk premium, credit premium, value, momentum, carry, et cetera) that allows their portfolios to grow sufficiently to meet future real liabilities. These investors, then, are willing to pursue higher returns in the vast majority of future market states, even if it means increased losses in a few states.
I personally imagine this as if the investor sensitive to failing slow has piled up all their risk – like a big mound of dough – in the bad outcome states of the world. For their willingness to bear this risk, they earn more return in the good outcome states. The investor sensitive to failing fast, on the other hand, smears that mound of risk across all the potential outcomes. In their unwillingness to bear risk in a particular state, they reduce return potential across all states, but also avoid the risk of catastrophe.
Quantitatively, we saw exactly this trade-off play out in our piece The New Glide Path, where we attempted to identify the appropriate asset allocation for investors in retirement based upon their wealth level. We found that:
- Investors who were dramatically under-funded – i.e. those at risk of failing slow – relative to real liabilities were allocated heavily to equities.
- Investors who were near a safe funding level – i.e. those at risk of failing fast – were tilted dramatically towards assets like Treasury bonds in order to immunize their portfolio against fast failure.
- The fortunate few investors who were dramatically over-funded could, pretty much, allocate however they pleased.
We believe this same failing slow and failing fast framework can also inform how trend equity strategies – like those we manage here at Newfound Research – can be implemented by allocators.
In our recent commentary Three Applications of Trend Equity we explored three implementation ideas for trend equity strategies: (1) as a defensive equity sleeve; (2) as a tactical pivot; or (3) as an alternative. While these are the most common approaches we see to implementing trend equity, we would argue that a more philosophically consistent route might be one that incorporates the notions of failing fast and failing slow.
In Risk Ignition with Trend Following we examined the realized efficient frontier of U.S. stocks and bonds from 1962-2017 and found that an investor who wanted to hold a portfolio targeting an annualized volatility of 10% would need to hold between 40-50% of their portfolio in bonds. If we were able to magically eliminate the three worst years of equity returns, at the cost of giving up the three best, that number dropped to 20-30%. And if we were able to eliminate the worst five at the cost of giving up the best five? Just 10%.
One interpretation of this data is that, with the benefit of hindsight, a moderate-risk investor would have had to carry a hefty allocation to bonds for the 55 years just to hedge against the low-probability risk of failing fast. If we believe the historical evidence supporting trend equity strategies, however, we may have an interesting solution at hand:
- A strategy that has historically captured a significant proportion of the equity risk premium.
- A strategy that has historically avoided a significant proportion of prolonged equity market declines.
Used appropriately, this strategy may help investors who are sensitive to failing slowly tactically increase their equity exposure when trends are favorable. Conversely, trend equity may help investors who are sensitive to failing fast de-risk their portfolio during negative trend environments.
To explore this opportunity, we will look at three strategic profiles: an 80% U.S. equity / 20% U.S. bond mix, a 50/50 mix, and a 20/80 mix. The first portfolio represents the profile of a growth investor who is sensitive to failing slow; the second portfolio represents a balanced investor, sensitive to both risks; the third represents a conservative investor who is sensitive to failing fast.
We will allocate a 10% slice of each portfolio to a naïve trend equity strategy in reverse proportion to the stock/bond mix. For example, for the 80/20 portfolio, 2% of the equity position and 8% of the bond position will be used to fund the trend equity position, creating a 78/12/10 portfolio. Similarly, the 20/80 will become an 12/78/10 and the 50/50 will become a 45/45/10.
We will use the S&P 500 index for U.S. equities, Dow Jones Corporate Bond index for U.S. bonds, and a 1-Year U.S. Government Note index for our cash proxy. The trend equity strategy will blend signals generated from trailing 6-through-12-month total returns, investing in the S&P 500 over the subsequent month in proportion to the number of positive signals. Remaining capital will be invested in the cash proxy. All portfolios are rebalanced monthly from 12/31/1940 through 12/31/2018.
Below we report the annualized returns, volatility, maximum drawdown, and Ulcer index (which seeks to simultaneously measure the duration and depth of drawdowns and can serve as a measure to a portfolio’s sensitivity to failing fast) for each profile.
Source: Global Financial Data. Calculations by Newfound Research. Returns are backtested and hypothetical. Past performance is not a guarantee of future results. Returns are gross of all fees. Returns assume the reinvestment of all distributions. None of the strategies shown reflect any portfolio managed by Newfound Research and were constructed solely for demonstration purposes within this commentary. You cannot invest in an index.
For conservative investors sensitive to the risk of failing fast, we can see that the introduction of trend equity not only slightly increased returns, but it reduced the maximum drawdown and Ulcer index profile of the portfolio. Below we plot the actual difference in portfolio drawdowns between a 12/78/10 mix and a 20/80 mix over the backtested period.
While we can see that there are periods where the 12/78/10 mix exhibited higher drawdowns (i.e. values below the 0% line), during major drawdown periods, the 12/78/10 mix historically provided relative relief. This is in line with our philosophy that risk cannot be destroyed, only transformed: the historical benefits that trend following has exhibited to avoiding significant and prolonged drawdowns have often come at the cost of increased realized drawdowns due to a slightly increased average allocation to equities as well as self-incurred drawdowns due to trading whipsaws.
On the opposite end of the spectrum, we can see that those investors sensitive to failing slowly were able to increase annualized returns without a significant increase to maximum drawdown. We should note, however, an increase in the Ulcer index, indicating more frequent and deeper drawdowns.
This makes sense, as we would expect the 78/12/10 mix to be on average over-allocated to equities, making it more sensitive to quick and sudden declines (e.g. 1987). Furthermore, the most defensive the mix can tilt is towards a 78/22 blend, leaving little wiggle-room in its ability to mitigate downside exposure. Nevertheless, we can see below that during periods of more prolonged drawdowns (e.g. 1975, 1980, and 2008), the 78/12/10 mix was able to reduce the drawdown profile slightly.
In these backtests we see that investors sensitive to failing fast can fund a larger proportion of trend equity exposure from their traditional equity allocation in an effort to reduce risk while maintaining their return profile. Conversely, investors sensitive to failing slow can fund a larger proportion of their trend equity exposure from bonds, hoping to increase their annualized return while maintaining the same risk exposure.
Of course, long-term annualized return statistics can belie short-term experience. Examining rolling return periods, we can gain a better sense as to our confidence as to the time horizon over which we might expect, with confidence, that a strategy should contribute to our portfolio.
Below we plot rolling 1-to-10-year annualized return differences between the 78/12/10 and the 80/20 mixes.
We can see that in the short-term (e.g. 1-year), there are periods of both significant out- and under-performance. Over longer periods (5- and 10-years), which tend to capture “full market cycles,” we see more consistent out-performance.
Of course, this is not always the case: the 78/12/10 mix underperformed the 80/20 portfolio for the 10 years following the October 1987 market crash. Being over-allocated to equities at that time had a rippling effect and serves to remind us that our default assumption should be that “risk cannot be destroyed, only transformed.” But when we have the option to adjust our exposure to these risks, the benefit of avoiding slow failure may outweigh the potential to underperform slightly.
This evidence suggests that funding an allocation to trend equity in a manner that is in line with an investor’s risk sensitivities may be beneficial. Nevertheless, we should also acknowledge that the potential benefits are rarely realized in a smooth, continuous manner and that the implementation should be considered a long-term allocation, not a trade.
Investors must navigate a significant number of risks throughout their lifecycle. At Newfound, we like to think of the two driving risks that investors face as the risk of failing fast and the risk of failing slow. Much like Odysseus navigating between Scylla and Charybdis, these risks are at direct odds with one another and trying to avoid one increases the risk of the other.
Fortunately, which of these risks an investor cares about evolves throughout their lifecycle. Young investors typically can afford to fail fast, as they have both future earning potential and time on their side. By not saving adequately, or investing too conservatively, however, a young investor can invite the risk of slow failure and find themselves woefully underfunded for future real liabilities. Hence investors at this stage or typically aggressively allocated towards growth assets.
As investors age, time and earning potential dwindle and the risk of fast failure increases. At this point, large and prolonged drawdowns can permanently impair an investor’s lifestyle. So long as real liabilities are sufficiently funded, the risk of slow failure dwindles. Thus, investors often de-risk their portfolios towards stable return sources such as high-quality fixed income.
We believe this dual-risk framework is a useful model for determining how any asset or strategy should fit within a particular investor’s plan. We demonstrate this concept with a simple trend equity strategy. For an investor sensitive to slow failure, we fund the allocation predominately from bond exposure; for an investor sensitive to fast failure, we fund the allocation predominately form equities.
Ultimately – and consistent with findings in our other commentaries – a risk-based mindset makes it obvious that allocation choices are really all about trade-offs in opportunity (“no pain, no premium”) and risk (“risk cannot be destroyed, only transformed.”)