The stock market crash of 1929 was a pivotal event that rippled across the globe. The Great Crash rocked financial markets, not to mention the world economy, and proved to be a precursor to the Great Depression. The sudden selloff wiped out the fortunes of investors who were ill prepared to ride out a bear market. Today, investors must heed the lessons from volatile markets of the past and take stock of hidden risks that may reveal themselves as current market conditions evolve. What strategies can investors employ to mitigate downside risks in their portfolios?
This episode of The Outthinking Investor examines risk through the lens of alternatives. Experts discuss the challenges investors face in making the right decisions for their portfolios, taking a holistic view of diversification, and the role that alts can play in both managing risk and capturing opportunities that emerge from volatility. Hear from Victor Haghani, founder and CIO of the wealth advisory firm Elm Wealth and co-founder of Long-Term Capital Management; and Ryan Kelly, Head of Special Situations for PGIM Fixed Income.
Episode Transcript
>> The Great Crash of 1929 was a massive and mostly unexpected drop in the US stock market that rocked the world's financial markets. The Dow Jones Industrial Average plummeted 23% in two days, wiping out the fortunes of many investors. In hindsight, economic warning signs were flashing, but investors were ill-prepared. One famous economist even proclaimed stock prices have reached what looks like a permanently high plateau. But few investors today know about the financial crisis that followed the Great Crash. What started as a regional banking crisis in 1930 quickly spread and was worsened by political instability and international events. A run on the banks spiraled. The New York Federal Reserve was even drawn into the crisis, unable to borrow to cover its own needs. Finally, in 1933, newly elected President Roosevelt suspended the gold standard, ending the crisis. Investors who had enough of a cushion to ride out the 1929 crash and the 1930s crisis fared better than those who didn't. As the saying goes, "Liquidity is the oxygen of our financial markets." We rarely notice it until it's no longer available. Are investors today heeding these lessons of preparing for the next storm while the sun is still shining? What are today's flashing warning signs? And should we be bracing for the impact of another market event?
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To understand today's investment landscape, it's important to know how we got here. This is The Outthinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. Victor Haghani is founder and CIO of the wealth advisory firm Elm Wealth and was a co-founder of Long-Term Capital Management. His recent book, "The Missing Billionaires," explores how investors make financial decisions in the face of uncertainty. Apostolos Katsaris is a senior client portfolio manager for PGIM Wadhwani, a quantitative multi-asset macro specialist. Ryan Kelly is head of special situations for PGIM Fixed Income and senior portfolio manager for the firm's Special Opportunities Fund. The 1930s crisis seemed to be a perfect storm, including a regional banking crisis, political instability, and international events. Today, some of these same triggers could be brewing. Policymakers and regulators are wiser, having learnt a lot from past crises, but what about investors? Victor Haghani's recent book starts with the premise that few of today's wealthiest people trace their wealth back to the early 1900s. That's surprising, because there was considerable wealth at the time and because US equity returns over the last 100 years or so averaged around 10% per year despite the Great Crash and the 1930s crisis. So why did the markets not produce more billionaires? Victor Haghani explains the common thread.
>> Investment decisions have two parts. First, you have to decide what it is that you want to invest in. What risks do you want to take? What do you select as your attractive investments? But then once you've done that, you have to decide how much. The "how much" question is the more consequential one to answer because if you get that wrong, even if you have good investments but you take too much risk, you can go bankrupt before those investments ultimately pay off. Whereas if you choose poor investments, but you size them correctly, you can survive and learn and invest for another day and recover from that. It's getting the "how much" decision right that's more consequential, and that very little thought or coverage or discussion is given to that.
>> An experiment Victor worked on several years ago demonstrates the difficulty in answering the question of how much risk to take.
>> We programmed a game where we told people and we programmed a coin to land 60% of the time on heads and 40% on tails randomly, and we gave people $25 and told them that they could bet on this coin for a half an hour, betting as much or as little as they wanted of however much they had of the $25 either grown it to or contracted it to. And then we'd pay them however much they grew it to at the end, subject to a cap that we'd tell them about, which was $250 cap. And we kind of figured that people would do pretty well and we'd have to pay everybody a lot of money, but we were somewhat taken aback by how poorly these subjects of our experiments did.
>> In fact, 25% of the people who played the game lost all their money betting on this biased coin. To add insult to injury, these weren't random subjects from the general population. They were either financial professionals or masters of finance students. So how should they have played the game?
>> One of the simplest and best ways to play the game is to choose a constant fraction of your bankroll to bet, maybe 10% to 20% on each flip, and just keep on betting that. So if your bankroll is going up, you bet more. If it goes down, you bet less. And you kind of stick with that constant percentage. And that percentage should be in that 10% to 20% region. If you bet 100 times and you got tails 40 times and heads 60 times, but you bet 50% of your money on heads every time, even though the heads came up 60 out of 100 times, you would actually lose money because that up and down hurts so much. Even though there was a net, 20 wins that you had, that wouldn't outweigh the losses from the up and downs. That's how risk eats return.
>> The participants may have been well-versed in financial theory, but everyone is prone to cognitive bias.
>> We saw a good number of cognitive biases. I think the most prevalent ones were these ideas of the fallacy of control, that somehow I think people were overconfident in their ability to predict whether it was going to be heads or tails. And something like 25% of the subjects bet on tails multiple times, generally after a string of heads, when they felt like a tails was due. So that was probably one of the biggest ones that we saw, was this idea of being able to control randomness.
>> The potential to control randomness is certainly alluring. That may be especially true for investors today given the massive expansion of both the types and amount of risk in the financial markets over the past 25 years or so. Apostolos Katsaris highlights why it's important to understand where the big risks lie today.
>> Twenty-five years ago, we were in the middle of a dot-com bubble. The only game in town was the US stock market, US mega-cap. Today it appears to be the same. And 20 years ago, Chinese equity markets were less than half a trillion. Today they are almost 10 trillion. Private markets, something that drove really the endowment model, went from 600 billion to 13 trillion today. And this is with the arrival of private credit, of private equity, of venture capital, and all other forms of private markets. You've had these undercurrents that have really pushed the limits of finance, and the limits of regulation, and the limits of products on offer, and the limits of products that are demanded by investors.
>> How has this evolution influenced the risk mindset of investors and how investors think about their risk budget?
>> Institutionalization of investment processes over the past 25 years have slowed the speed of decision-making. So everything is about ex-ante risk management. The following of an endowment-type model with an ever-increasing share of illiquid markets has also meant that investors need to think about ex-ante risk management because once you commit to private markets, there's very little you can do afterwards. You have an ever-increasing need for external validation of investment processes, and that's why you've had the arrival of consultants, particularly after the global financial crisis. Combine that with regulators forcing -- for example, in certain geographies, forcing benchmarks that may or may not be the most optimal investment portfolio for long-duration investors to hold. But what you've had is the unintended consequence of this regulatory reach has been that now you have very homogeneous portfolios of institutional investors in certain regions in the world. Moreover, the endowment model that many people want to emulate has meant that investors have been flocking to private markets, but this has had the unintended consequence of leading to liquidity risk, rebalancing risk, and payout risk. The vast majority of our returns are going to come from a strategic asset allocation, and we can only go around the edges in terms of tactical asset allocation to add some alpha. It has actually meant that you now have valuation challenges within your strategic asset allocation. You have investors today that are a lot more drawdown-conscious because of what happened in 2022. You have your liquid portion, the only component that you are able to sell down or draw down on, so that you can pay out if you're an endowment, or you can rebalance if you want to take some active decision within your investment portfolio.
>> Another result is that today's institutional investors are much more sophisticated in how they think about their public and private asset mix, especially in their role as a limited partner, or LP. That's enabled a lot of opportunities. But as Ryan Kelly explains, there is no free lunch.
>> Every investor, every LP has a large bench and a lot of strategies that they have to look after. So keeping track of all that, staying on top of the disclosure, and really fully understanding what those managers are doing and how they're performing is a challenge unto of itself. And so that's one end of it. And then two, as you get across a lot of these different strategies, there's a lot of liquidity that's being linked to one another across these strategies. So there's a liquidity pacing element to it. And when everything's working well, that's great. But when things start to slow down -- liquidity doesn't get recycled as fast as people would like it, it starts to create some challenges. More recently, that recycling activity has slowed dramatically. We would see six to $700 billion of exits in private equity every year, be it through M&A strategic or IPOs, and that has plummeted to sub $100 billion, and so that's created a bit of a liquidity squeeze in the LP channel. Not a pervasive problem but highlighting the complexities that are out there. But again, I think that's more coming from a heightened level of sophistication and awareness from the LPs themselves.
>> The fact that so many institutional portfolios have adopted similar asset mixes also raises a red flag.
>> This suggests that there is some crowding and concentration risk in investment portfolios. When you also have the flocking behind strategies that have worked very well over, say, the last decade, then this means that potentially, institutional portfolios are exposed to investment vehicles that have hidden concentration risk and hidden leverage that is not fully understood or fully digested within their alternatives portfolio. Herding behavior also means that you have this reduced liquidity, particularly during times of stress. What most people try to do is funnel execution to the most liquid, narrow channel, which tends to disappear when things get tough. So when everybody starts to run for the door, unfortunately, that door narrows in size. Investors need to fully grasp what is the liquidity risk that they have exposed themselves to. What is the rebalancing risk? What is the payout risk? Do they have the ability to meet their liquidity requirements? And they have to look at risks from a different perspective as to, is this market accessible to me for this investment horizon. Do I have the ability to exit these exposures when I need it most?
>> So what's the solution to increasing liquidity risk? A perfectly reasonable response might be a more diversified portfolio, or it might not be.
>> Building a diversified portfolio has led to the unintended consequence of exposing investors to these other risks that they weren't necessarily fully cognizant of when they were making these decisions. So the risk mindset has been, instead of looking at volatility of a book, now you have to think of risk in many different dimensions, including liquidity, including governance, including career risk in some cases. Today's world is very different to what it was 25 years ago. We have a whole generation of finance professionals that have been taught that there is always a buyer of last resort that is going to bail you out. If you've only experienced that central banks are always going to come and put a floor in the market, that is potentially setting you up for a very, very challenging environment, going forward, if that Fed put, so to speak, disappears.
>> For some investors, moving a portion of their portfolio from illiquid alternatives to liquid alternatives could add a buffer without substantially impacting their expected returns.
>> So obviously, liquid alternatives that can offer some diversification -- and we saw that that is the case in 2022 -- liquid alternatives can offer some substantial diversifying returns, not only in a 2022 world where traditional asset classes are challenged but also during a world where you have only a few asset classes delivering on their expected returns. And therefore, you need some genuine diversification within your portfolio or a different source of return that can cushion the blow and increase the diversification and reduce the volatility of your portfolio. Now, to genuinely achieve this, what you need is diversification of asset classes as well as strategy, but you also need agility. In this uncertain world, you also need discipline. And that has led to a re-emergence of demand to process-driven investing or quantitative investing.
>> What are investors actually doing today, and where are they looking for return?
>> Investors today are focusing on what has worked more recently, and I would argue that they are not as long-term-oriented as they typically are. There is a structural sort of change in the markets where there's a desire to go up in quality and stay in quality. You're seeing that across the equity markets. You're seeing that across the credit markets. And that quality bias has become more pronounced over the last bit of time, but there is a quality bias that has overtaken a lot of the desires for investors. And so the reason we suspect that's happening is there's a fear that -- you know, given this historical rate hiking cycle around the world, there's a lot of uncertainty, obviously. And so the best way to play the uncertainty is to go into that high information ratio, high Sharpe ratio sort of trades that have minimal downside risk. Today, we live in a world where there's a lot of asymmetrical downside risk in certain sectors, certain markets. So in a way, they're not really playing the long game; they're trying to preserve capital because they do expect to see more volatility, more drawdown risk emerging over the coming quarters and years as we get into this sort of renormalization of rates and markets.
>> Even in today's environment of heightened uncertainty, this seems short-sighted. Perhaps applying Victor Haghani's insights about how much risk to our everyday investment decisions can help align short-term and longer-term goals and strategies.
>> Well, I think the really important thing to realize in sizing decisions, in this "how much" decision, is that what we want to maximize is not expected return. It's not expected wealth. It's some kind of risk-adjusted wealth or risk-adjusted return. And we all know that, but we have to be really careful that we don't fall into a trap of maximizing expected value or expected money or expected return. And this is really what Sam Bankman-Fried said he was trying to do, and we know how that wound up. And that's what happens if you really are trying to maximize your expected return. Say in our coin flip game, the strategy that maximizes your expected return is to bet all of your money on heads every time. Well, that's insane. Nobody would do that. But that actually, mathematically, is what maximizes your expected return. But we need to maximize risk-adjusted return. And to maximize risk-adjusted return, we have to put a price on risk. Because the more we bet, the higher our return is, the higher our expected gain is. But the more that we bet, the higher our risk is, and there has to be a cost put on that. And that cost on risk has to go up faster than the gain from betting more so that we hit some maximum.
>> A few decades ago, one answer to maximizing risk-adjusted returns would have been the 60/40 portfolio. But since then, it's gotten a bad rap, while institutional portfolios that moved to the endowment model benefited from a two-decade surge in the private markets. Isn't this a case where focusing on the question of how much risk to take has not actually paid off?
>> The 60/40 portfolio or risk-parity portfolio paradigm, these are answers to the question of how much risk you're taking at different points in time. Somewhere in there is this risk decision. And I think that both of those paradigms or icons of asset allocation really don't stand up very well to scrutiny in the sense that we know that the expected returns, the expected risk premia of risky assets is changing over time. We know that the return, the expected return on safe assets is changing over time, and we know that the riskiness of the markets are also changing over time. And we know that answering the question of "how much" is a function of how attractive are these investments and how risky are they. The riskier they are, the less we want; the higher the expected return, the more we want. And both of these are relatively static approaches to investing that assume that the world is always the same. I don't know, the same as what? Maybe the same as it averaged over some historical period of time. So I think that both of them are pretty suboptimal in terms of how people should be making their "how much" decisions.
>> Even if the question of how much risk to take is most important, investors also need to address the question of where to allocate their risk today.
>> Rather than backing the investment styles, the asset classes, and the investment vehicles that have performed really well over the last decade, investors need to be cognizant that diversification comes in many different forms and tends to disappear, and what we all thought was a diversified book didn't actually work in 2022. That's why it's important for investors to look for hidden opportunities or unloved strategies that can deliver in a changing world. Now that makes the case for strategies like quantitative strategies that will do what they say on the tin or for strategies that are process driven so that you can actually potentially generate some positive returns and therefore be able to draw down that capital in a liquid fashion -- if your liquid book is hurting -- to use that to fund capital calls of your illiquid book. That is one option. The other option would be to go and find genuine diversifying or tail risk strategies on your liquid book to hedge or diversify the equity drawdown risk that you have. And there is some increased demand by institutional investors to strategies like these, but once again, all these have to be, in my opinion, process-driven because you need them to behave in a known fashion.
>> And while there may be warning signs that the world is changing, we don't know when the next major risk event will occur or what it will be. Victor Haghani's experience at LTCM shows the damage a liquidity event can do to even a rigorously constructed portfolio.
>> It really led me to question this "how much" decision. Anybody that's looked at what we had invested in felt like okay, in the long term, these are good investments. And indeed most of them even worked out some years after LTCM's demise, but we were too big in those investments and we weren't able to benefit from their ultimate working out. Any leverage pool of capital like LTCM is always going to be subject to large losses. That's the nature of using a lot of leverage. Still though, I think that we didn't probably spend enough time or -- certainly, in hindsight, that's clearly the case that we didn't get the sizing decisions right for our capital and the trades that we had.
>> Investing in the face of heightened uncertainty will always be a challenge, but investors can maintain a healthy respect for risk while still pursuing diversified returns. As our guests explained, stay focused on how much risk you take, look for credit and special opportunities as they arise during challenging environments, and consider quantitative and tail risk strategies that can add a buffer in times of market stress. Thanks to our three experts for their keen insights on managing risk in the face of uncertainty. The Outthinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review.