I decide to take the events of the past two weeks to reflect about the mis-priced events and expectations. This year has seen two such situations present themselves – namely Brexit in the UK and the Presidential Election in the United States.
Both situations had binary outcomes. Markets mis-priced the outcome wrongly in both instances, and reacted violently initially when it became apparent they had misjudged the situation.
There are a couple of points I like to draw from these two events.
Firstly, predicting the outcome of major events and taking huge directional bets on it is a very tough to get right consistently. One not only has to be right on the outcome, but also the reaction of the markets.
I remember the night when it became apparent Trump was clearly winning. Futures in the US plunged precipitously and fell 5%. In Asia, markets were open and sold off hard.
By the time of opening bell however, investors had recovered from their shock and narrowed their losses dramatically, and markets actually rallied!
So much for the end of days that Trump was supposedly about to bring about.
Investors who were right, but were not quick footed enough may have initially racked up huge gains, only to find themselves taking huge losses days later.
Not a pretty situation in any case.
So far we’ve established that investors so far have to:
- Get the outcome correct
- Get the timing of their trades right in response to the outcome
But I think the most under looked point is actually:
The payout if an investor is right, or the potential loss if an investor is wrong
I’ve seen the above point articulated in many different ways but my preferred interpretation is quite simple.
We want a situation whereby any investment we make as an asymmetrical risk/reward payout.
This really feeds into the idea of risking 20-30 cents to make $1.
The idea is not very far off from buying travel or medical insurance. None of us would like to make a claim, but in the case we need to, our payout is normally in multiples of our paid premiums.
The whole idea of a trade with an asymmetrical risk/reward payout was articulated excellently in The Greatest Trade Ever and in Michael Lewis’s excellent book, the Big Short. It’s since been made into a movie which I highly recommend.
On the reverse end, my own general observation is that many investors tend to act quite differently by risking $1 to make 5 to 10 cents.
My observation on trades placed on events with binary type outcomes is that you are either right or wrong. And if you’re wrong, and you’ve used leverage on the trade, things can get very dicey as investors head to exit at exactly the same time.
How we position ourselves:
My personal preference simply has to hold higher levels of cash going into such events to take advantage of any market dislocations that may occur purely out of emotional sentiment.
As value investors, I’ve never been too keen on the idea of macro-economic forecasting. If “experts” who had every vested interest of getting it right were this wrong on an event with a simple binary outcome – I cant imagine economic forecasting to be any easier given the wide myriad of outcomes.
Still, let me draw a distinction between marco-forecasting and knowing where we are in the cycle which I think is a much more achievable goal.
I always like to liken the market to a pendulum – swinging from greed to fear and back again. The most extreme the swing to one end, the quicker the pendulum swing backs.
Although we do not know exactly know when the pendulum will change course, I still think its extremely important to know where we are in the cycle.
When others are overly optimistic, we are far more cautious. Conversely, when fear permeates the news, we get more aggressive.