Quote of the Day: Own More of the Good Type of Risk

Uncertainty should not bother you. We may not be able to forecast when a bridge will break, but we can identify which ones are faulty and poorly built. We can assess vulnerability. And today the financial bridges across the world are very vulnerable. Politicians prescribe ever larger doses of pain killer in the form of financial bailouts, which consists in curing debt with debt, like curing an addiction with an addiction, that is to say it is not a cure. This cycle will end, like it always does, spectacularly.

When it comes to investing in this environment, my colleague Mark Spitznagel articulated it well: investors are left with a simple choice between chasing stocks that have an increasing chance of a crash or missing out on continued policy effects in the short term. Incorporating a tail hedge minimizes the risk in the tail, allowing investors to remain invested over time without risking ruin...

To be robust, one must construct a portfolio as an engineer would a bridge and ask what your managers expect to lose should the market fall by 10%. Then ask them again what they’d expect to lose in the down 20% scenario. If that second number is more than two times more painful emotionally than the first, your portfolio is fragile. To fix the problem, add components to your portfolio that make the portfolio stronger in a crash, like actively managed put options. You will be able to build stronger, better bridges, with better returns, that will last for the long term.

By clipping the tail, you can own more risk, the good type of risk: upside with limited downside. And rather than helplessly watching your bridge collapse, you can be opportunistic in a crash, and take the pieces from others at bargain prices to increase the size of yours.

This excerpt is from iconoclast risk analyst and author Nassim Taleb at the Hedgefundintelligence.com

China’s Sovereign Wealth Fund in the Red

Many think that government (central banking) surpluses should be ‘invested’ through loans or through financial markets as sovereign wealth funds. They solely look at the benefits of the supposed ‘investments’ while ignoring both the hidden and the visible costs.

The recent losses of China’s sovereign wealth fund should be an example.

From CNN,

China's sovereign wealth fund suffered its worst year ever in 2011, losing 4.3 per cent on its global investment portfolio.

In an annual report that has become the focal point of its efforts to portray itself as a transparent institution, China Investment Corp also confirmed that it had received a $30bn capital injection from the government at the end of last year, boosting its investment firepower.

CIC was established in 2007 with money carved out from China's foreign exchange reserves and given a mandate to make investments that would generate higher returns. However, it quickly ran into concerns about its government background and so has been at pains to demonstrate that it is a long-term investor focused on profits, not politics.

In its annual report CIC emphasised that point, noting that its board decided in 2011 to make rolling 10-year annualised returns a key measure of performance.

"As a long-term investor, we are well positioned to withstand short-term volatility in markets, to pursue contrarian investments and to build long-term positions that can capture the premium for less liquidity," it said.

There is no guarantee that government ‘investments’ will produce positive returns.

After all, government and central bank bureaucrats are human and suffer from the same knowledge problem, as well as, other human frailties (heuristics, biases, etc..) as with the rest.

The difference is that government actions has externality effects which unduly exposes taxpayers. Yes, central banks as government institutions are underwritten by taxpayers.

The other difference is that actions by government agents or bureaucrats are driven by legal technicalities and political priorities than from the profit and loss incentives.

Besides given the huge distortions of the marketplace financial assets are subject to immense volatility and boom bust cycles, which makes sovereign wealth funds highly susceptible to market risks.