The best thing in your portfolio may be the one that loses money nine years out of ten.
Suppose you are choosing between two assets over a decade. The first gains 10% a year for nine years and loses 40% in the tenth, when a crisis hits. The second loses 2% a year for nine years and gains 50% in the crisis year. The first averages 5% a year, the second barely 3%, and the second spends nine years out of ten making you poorer. Almost any comparison says to pick the first.
Now hold half of each and rebalance every year. In the calm years the pair gains 4%; in the crisis year it gains 5%. After ten years the combination has grown about 49%, against about 41% for the first asset alone. Adding the asset with the worse average and the worse track record made the whole portfolio richer. How?
A product, not a sum
The answer is that a portfolio’s return over time is a product of its yearly returns, not a sum. A sum can absorb a terrible year and carry on. A product carries every loss forward: a 40% loss needs a 67% gain to recover, and a 50% loss needs 100%, and the years spent recovering are years not compounding. That is the non-ergodic logic of investing, and it is why drawdown matters more than average return. The second asset was valuable because it moved the opposite way at the one moment the first was being cut down. Anti-correlation is worth more than excess return.
Rebalancing is what turns that into money. Each year the portfolio sells some of whatever rose and buys whatever fell, so in the crisis it sells the asset that jumped 50% to buy the one that just collapsed, at a low price. Diversification and rebalancing between uncorrelated assets shift a portfolio’s result from its geometric mean toward its arithmetic mean, one of the few genuine free lunches in finance: the volatility that wrecks individual positions becomes a source of portfolio-level gain.
The serpent and the hawk
Artemis Capital names the two kinds of asset with an allegory. The Serpent is the asset that earns steady gains during stability and growth in exchange for substantial loss when the world changes: equity, credit, real estate, private equity. Leverage is applied to stability. Its returns look excellent precisely because buffers against tail events are being optimized away, and in the Minsky cycle the longer the calm lasts, the more capital flows into serpent assets and the harder the eventual correction.
The Hawk is the opposite: an asset that bleeds a little or goes nowhere during stability, then produces exponential gains during disorder. Gold, volatility strategies, commodity trend following and global macro trading are hawk assets, structurally antifragile because they gain from the disorder that destroys the serpent. The first asset in the example is a serpent; the second is a hawk.
Most people’s exposure is more serpent than their portfolio suggests. The income that funds the portfolio, wages, business revenue, tax receipts, rises and falls with the same economic growth as the stocks. When growth fails, the portfolio falls and the money to buy the dip disappears at the same moment. The dangerous correlation is not only between assets but between the assets and the investor’s ability to hold them. So the purpose of a defensive asset is not to make money — it is to make the portfolio survivable.
Hedges that stop hedging
The limit of all this is that anti-correlation is a property of a regime, not of an asset. For forty years bonds were the standard hedge, as policymakers cut rates from 19% in 1981 to zero by 2009, and portfolios came to depend on bonds rising whenever stocks fell. Over longer history, though, stocks and bonds have spent more time correlated than anti-correlated. Assuming bonds will always hedge equities is the same category of error as the pre-2008 belief that home prices could not fall nationwide: a pattern from one era mistaken for a law.
Hawks have a cost of their own, too. In the example, the second asset lost money for nine straight years, and few investors hold anything through nine years of losses without starting to wonder why they own it. The protection only pays if you still own it on the day it is needed. The serpent promises growth. The hawk promises survival. And survival is the precondition for everything else. The hard question is whether you can tell which of your assets will still be hawks when the next crisis arrives.
References:
- Artemis Capital Management, The Allegory of the Hawk and Serpent
- Breaking the Market, A Grand Unified Theory of Market Behavior