On Risk; a Potential China Breakout?; Low Fat Versus Low Carb Diets?!

From: aditya rana
Date: Sat, Sep 6, 2014 at 2:24 PM
Subject: On Risk; a Potential China Breakout?; Low Fat Versus Low Carb Diets?!

Hi!,

Risk control is perhaps the single most important factor in managing an investment portfolio successfully over time, and especially given the currently buoyant market conditions, it would be foolhardy not to pay adequate attention to it. There are few people who think (and write) about risk more insightfully than Howard Marks, a 45 year veteran of the credit markets and Chairman of the well known credit manager Oaktree Capital. His periodic memos are always a worthwhile read, and the latest one on risk is a real gem. To summarise:

-Volatility (or fluctuation) and risk are two different things, with the former being popular with academics as it is quantifiable. Risk is about permanent loss of an investment.

-A permanent loss can result due to two reasons: 1) a temporary dip is locked-in as the investor is forced to sell due to financial reasons, a margin call or emotional factors, or 2) the investment is unable to recover due to fundamental reasons.

-Risk is difficult enough to measure before the event – it can’t be measured even after the event. For example, it may rain tomorrow or it may not, but whatever happens tomorrow does not inform you what the probability of rain was as of today.

-The future is unknowable – in the words of John Kenneth Galbraith "We have two classes of forecasters. Those who don’t know – and those don’t know they don’t know".

-With the almost infinite number of factors which can influence the future, their randomness and the weaknesses of these linkages, the future cannot be predicted with any consistency.

-However, this presents a peculiar challenge for investing – as one has to decide how to position a portfolio for the future – which is itself unknowable.

-The key method to deal with this is to view the future, not as a fixed outcome but as a range of possibilities, together with insights into their likelihoods.

-However, this requires experience in the relevant area and by its nature the risk estimate will be subjective, imprecise, and more qualitative than quantitative. As Albert Einstein said "Not everything that counts can be counted, and not everything that than can be counted counts". Or as put slightly differently by Carveth Read: " It is better to be vaguely right than exactly wrong".

-Successful investing is about finding asymmetries – where the upside potential exceeds the downside risk – on a regular basis.

-The second key point to deal with risk is best expressed by the Elroy Dimson from London Business School: "Risky means more things can happen than will happen". This means that just because one event happened, it does not imply that a large number of variable outcomes had not existed.

-The third point is that knowing the probabilities of an event does not mean that you know what’s going to happen. "There is a big difference between probabilities and outcomes",and probabilities are only likelihoods.

-The fourth point is to realise that though "many things can happen, only one will." While calculating expected value by weighting all the possible outcomes by their probabilities can be helpful – eventually only one event will happen, which may unfortunately be totally unacceptable.

-Risk is conventionally illustrated by way of the following graph – i.e. risk increase as returns increase.

-However, if riskier investments do produce higher returns they cannot be viewed as risky. Risk is better illustrated by the graph below, where each level of risk shows a range of outcomes, and not a single outcome as suggested by the upward sloping line.

-The essence of investment risk is viewing riskier investments as having less certainty about the outcomes and realising that you might fare worse than those who make only safe investments, as well as having the possibility of losing money.

-In addition to the risk of permanent loss, there exists the risk of falling short of your objectives. There are two possible reasons for this: 1) targeting a high return and being subject to a negative event, and 2) targeting a low return and achieving it. Investors therefore face two major risks – the risk of losing money and the risk of missing opportunities. Either can be eliminated but not both.

-In today’s zero-rate environment, returns can be enhanced by borrowing to make an investment. This introduces two types of risk: 1) while returns can be magnified so could the losses, and 2) it introduces funding risk where short-term funding is taken to buy long-term assets – and if the funds have to be repaid at an awkward time due to their maturity or a margin call – then the assets may have be sold at an inopportune moment resulting in lower returns or a permanent loss. As the old market saying goes: "Never forget the six-foot-tall man who drowned crossing the stream that was five foot deep on average".

-In recent years, Oaktree has targeted a 10% return by managing credit risk, together with illiquidity risk, concentration risk and leverage risk.

-There are two main risks which can result in an unsuccessful investment: "fundamental risk" (how an asset performs in the real world) and "valuation risk" ( how the market prices that performance).

-Essentially, "the riskiest thing is to over pay for an asset (regardless of its quality), and the best way to reduce risk is to pay an irrationally low price which provides a margin of safety".

-Finally, the eight main takeaway points about risk:

1. Risk is counterintuitive – the riskiest thing in the world is the widespread belief that there is no risk.

2. Risk aversion is what keeps markets safe and sane and provides the potential for superior return.

3. Risk is often hidden and deceptive – the riskiness of an investment is only seen during a negative event.

4. Risk is multi-faceted and hard to deal with -it is impossible to come up with a single formula to manage all the myriad risks.

5. Risk management should be the responsibility of every participant in the investment process and not only designated to risk managers.

6.Risk needs to be dealt with constantly – investors are often tempted to do it only sporadically.

7. Risk control requires humility, lack of hubris and knowing what you don’t know.

8.While risk control in essential, risk avoidance usually results in return avoidance. Just as one cannot expect to make money just for taking risk, one should not expect to make money without taking risk.

-Charlie Munger (Warren Buffet’s partner) said it best: "It’s not supposed to be easy. Anyone who finds it easy is stupid".

-At present, Marks thinks that risk control is more important than usual, "as investor behaviour, while not sinking to the depths seen prior to the crisis, has entered the zone of imprudence. It is therefore more important to focus on loss prevention rather than the pursuit of gain." While he has no idea what may cause the next crisis to come earlier than later, what he does know is that the degree of risk being currently created does not have adequate return.

A remarkable piece which reiterates the need to be cautious in the current environment, which does not necessarily imply risk aversion, but rather taking risk cautiously. As a private investor I would add some extra points to his eight takeaways:

-Diversification (across assets and asset classes) is a key strategy to deal with an uncertain future.

-Being a contrarian (armed with a calculator!) is very helpful in dealing with the point about having an entry price with an adequate margin of safety.

-Patience is key to deal with volatility and turn it into an advantage with the passage of time. Most investment mistakes can be seen as temporary if give sufficient time (and thereby avoiding a permanent loss) – the key is to be able to survive until then!

With that I leave you with a final quote from the investment great and risk guru Peter Bernstein:

"After 28 years at this post, and 22 years before this in money management, I can sum up whatever wisdom I have accumulated this way: The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive. Performing that trick requires a strong stomach for being wrong, because we are all going to be wrong more often than we expect. The future is not ours to know. But it helps to know that being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future (maybe the real trick is persuading clients of that inexorable truth). Look around at the long-term survivors at this business and think of the much larger number of colourful characters who were once in the headlines, but who have since disappeared from the scene."

A China Breakout?

To follow-up on my newsletter from two weekends ago, Bloomberg had an interesting story which highlights signs of perhaps the beginnings of an investor rotation out of property and into stocks in China. With Chinese retail investors having only a 4% allocation to stocks (versus 55% to real estate and 22% in bank deposits) , and the success of government measure (perhaps too successful!) to cool the property market, the doubling of new equity brokerage accounts since May are a potentially early sign of this rotation.

If this gathers momentum over the next few months and quarters, it could be the final leg (in addition to cheap valuations, positive technicals-see graph below, and supportive policy changes like the Shanghai/HK "through-train") in building a base for a long term structural bull market in Chinese equities. While there have been a few false starts in recent years, a possible "Great Rotation" could be the game changer.

Low Carb versus Low Fat Diets?

The New York times was out with an article citing a study that a low-carb diet was better for reducing weight and cardiac risk than a low-fat diet. As is usually the case, it is helpful to get an opinion from an expert in the field on the study (and article!). I present below excerpts of a response from David Katz, founding director of Yale University’s Prevention Research Centre:

Huff Health 09/02/2014:

-The current diet study making headlines purportedly asked, and answered this question: Which is better for weight loss and improving cardiac risk, a low-fat or a low-carb diet? For starters, that is a truly lousy question, resurrected from something like the Stone Age.

-Why prehistoric? Because it is long known and well established that dietary fats run the gamut from good to bad to ugly. No good diet should willfully exclude the monounsaturated fats and omega-3s in nuts and seeds and avocados.

-There is ongoing debate today about specific effects of specific fats, but the wholesale cutting of dietary fat intake was pretty much yesterday’s news yesterday. The relevant concept today would be plant-based eating, which at the extreme of veganism, tends to be low in fat — but as an effect rather than an objective. This was not a study of a vegan diet.

-The concept of low-carb is also terribly outdated, and was silly when it was first spawned. Everything from lentils to lollipops is carbohydrate. Why on earth would anyone want to treat such a vast expanse of the food supply as if it were just one thing? Sillier still, all plant food is a carbohydrate source. A truly "low-carb" diet is, of necessity, low in all plant foods — including vegetables, fruits, nuts, seeds, beans, and lentils along with whole grains. This is directly at odds with everything we know about diet and health across the lifespan.

-The study didn’t even really ask this question. If you only read the headlines, you will believe it did — and frankly, most people will only read the headlines. I read the study — and before you start arguing with me, I invite you to do the same.

-It was published in the Annals of Internal Medicine, and frankly redounds much to the shame of this generally prestigious journal. Allegedly, the researchers compared a low-fat to a low-carb diet. But in fact, they compared a diet that allowed up to 30 percent of calories from fat to a diet that allowed up to 40 grams of daily carbohydrate.

-The baseline diets were, reportedly, roughly 2,000 calories per day on average among the nearly 140 obese study participants. That means the allegedly low-fat diet assignment allowed up to 600 calories per day from fat, while the low-carb assignment allowed only about one-quarter that much carbohydrate, 160 calories. The baseline fat intake of the participants in the low-fat assignment was just over 35 percent of calories, so this was, essentially, a diet intervention that didn’t intervene much with their diets.

-In contrast, baseline carbohydrate intake was 240 grams per day, so while fat intake was "trimmed" 5 percent, carbohydrate intake in that assignment was slashed 75 percent. This might have been billed "a study to compare a really big change from baseline diet to a really small change from baseline diet." I suppose we can all guess why it wasn’t called that.

-That would be bad and biased enough if the researchers had made any attempt to compare comparably good, or comparably bad versions of the two diets; but they did not. The "low-fat" diet was, for starters, not much lower in fat than the typical American diet, which as we all know — is basically crap. Shockingly, the fiber intake was virtually identical, at about 15 to 16 grams per day, in both groups throughout the study.

-You cannot possibly eat any variant on the theme of "good" low-fat, mostly plant-based eating and fix the fiber intake at that pitiful level. The only way to do that is to combine modestly low fat with preferentially crummy foods made mostly from refined starches and added sugars. The study did not provide this level of detail about the diets, but it’s clear that the low fat diet was (A) not low fat; and (B) rather crummy. So another title option was: "a comparison of the best low-carb diet to the worst low-fat diet we could come up with." Again, I think it’s clear why they didn’t go with that one.

-And finally, the low-carb diet, since it was actually low-carb, obviously was much more restrictive than the low-fat diet, which wasn’t actually low-fat. That had the predictable result: those on the low-carb assignment took in many fewer calories. Over the first several months of the study, when everyone was probably on their best behavior, the low-carb group took in about 200 fewer calories per day. All the way out at the 12-month mark, when folks were falling off the wagon, the low-carb assignees were still taking in nearly 100 fewer calories per day.

-And so, the results were a foregone conclusion. Over the span of a year, obese people who ate less, lost more weight. And those who lost more weight had more improvement in their cardiac risk measures — which were mostly a mess in the first place due to obesity.

-Folks, this is not a defense of low-fat diets. I am not an advocate of low-fat diets. I think the concept is obsolete. I am an advocate, based on the evidence, of wholesome foods in sensible combinations. That dietary pattern can be low or high in fat, relatively lower or higher in carbohydrate. The theme is pretty universal, but the variant on the theme that best suits you and your family is really up to you, and frankly — that’s the beauty of it.

-As a medical journalist, I am a proponent of reading past headlines. Headlines want to titillate you, not educate you. If you are comfortable, they are designed to afflict you. If you are afflicted, they are designed to comfort you. The truth, the whole truth, and nothing but the truth are for the most part — entirely expendable. Proceed accordingly.

-Essentially, the study was a comparison of a quite restricted, lower-calorie, low-fiber diet; to a less restricted, higher calorie, equally low-fiber diet. The first worked better for weight loss. Ignored in the mix? Was the diet sustainable when the intervention ended? Could families join in? Would the diet reliably improve health and prevent disease across a lifespan?

Here’s to not believing titillating headline news (on health or financial markets or anything else) – particularly if it confirms your own likings and beliefs!

Regards,

Aditya

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