The Virtuous Investor: Rule 13

Treat each fight as if it were your last – because if you don’t, it could be

This post is part of a series on The Virtuous Investor. For an overview of the series and links to the other parts, click here.

“But always take heed that thou fight with this mind and hope, as thou that should be the last fight that ever thou shalt have.”

Erasmus of Rotterdam

What does it mean to fight each fight as if it were your last? The answer I expect most of my readers to give is to fight with all the determination and force one can muster. And that is true. But so does Wile E. Coyote when he tries to catch Roadrunner.

The problem with Wile E. Coyote is that every time he tries to catch Roadrunner, he goes all in. And when his efforts inevitably fail as described by the Chuck Jones’ nine rules for writing Roadrunner cartoons, then he ends up dead – or as close to dead as is allowed in a cartoon. In any case, because Wile E. Coyote goes all in in every fight, it typically ends up being his last.

There are so many investors who act like Wile E. Coyote. The people who are convinced that stock markets are overvalued and thus would never buy stocks until they go back to the valuation levels of the 1980s. The people who think that negative yields on bonds make no sense and thus would never buy government bonds even if that means having no safety net when a recession hits. The people who are convinced that cryptocurrencies will replace fiat currencies and thus hold on to Bitcoin and co. into eternity. The list goes on.

These investors have one thing in common: They give up diversification and risk management in favour of one great investment that is going to save their portfolio. 

But the number rule if you fight a fight as if it were your last is to make sure you survive. As the German military strategist Helmuth von Moltke said:

“No battle plan survives first contact with the enemy.”

Similarly, no investment plan survives first contact with the market. Markets are chronically unpredictable, and things will go wrong, no matter how well you planned your investments. There are two ways how investors can make sure they survive even the most adverse circumstances. The first one is the only free lunch in investing: diversification.

Diversification means spreading your risks amongst investments that behave differently at all times. It does not mean to invest in four different US stock market ETFs (e.g. a small-cap and a large-cap fund, a biotech and an IT fund). The diversification benefits within the US stock market are much smaller than the diversification benefits available in global stock markets or across asset classes. Yet, after a decade of outperformance of US stocks vs. foreign stocks, so many investors are tempted to reduce their holdings in foreign stocks and focus predominantly on US stocks. 

Performance of global stock markets


So much has been written about diversification, that I can hardly add anything new. All I want to say here is that if you look at your portfolio and there aren’t any investments in it that you hate, then chances are, your portfolio isn’t well-diversified. Of course, the inverse is also true. If you look at your portfolio and there aren’t any investments in it that you love, it is likely not well-diversified either.

But diversification isn’t everything. For the virtuous investor to survive the battle, she has to learn something that bankers don’t often consider but insurance companies do all the time. Think about it. An insurance company knows that every single day, it underwrites contracts that will lead to a loss. That is the essence of the insurance business. You invest in a whole lot of contracts, some of which will make you money, some of which will trigger an insured event and will cost you dearly.

What do insurance companies do to avoid bankruptcy? They think about portfolio sizing. Insurance companies have learned that no matter what they do, they never enter risks that are so large that they can sink the entire company. 

Look at the behaviour of banks in the run-up to the financial crisis. Banks like Lehman Brothers or UBS were heavily exposed to subprime mortgage loans. But at UBS, for example, it is well documented that the company only looked at the net exposure to subprime mortgages after hedges were taken into account. But when the hedges failed during the crisis, UBS realized that what really mattered was the gross exposure. The bank almost went bankrupt and had to be bailed out by the Swiss National Bank who took on the $54 billion in bad debt on UBS’ books.

Insurance companies, and in particular reinsurance companies don’t usually make that mistake because if they do, they won’t survive for long. Reinsurance companies, in particular, know that the buck will stop with them. They can’t insure themselves against losses, because, well, they are the last one in the chain. So, they make sure they never have exposure to any single risks that could potentially wipe out their capital.

The virtuous investor should do the same with her portfolio.

Look at the portfolio and imagine any investment would go to zero. If your portfolio includes derivatives, then you even have to consider cases when your investments go into negative territory. And don’t think that just because you have a hedge in place you will be saved by the hedge. Options and swaps can and have failed when counterparties defaulted. Even if there is a central clearing mechanism, there is the potential that a financial crisis can become big enough that the central clearing house fails. In this case, your hedges fail. Are you going to survive that?

Similarly, don’t think that government bonds are a safe asset. Governments have failed in the past and will do so in the future. And if you think that the United States government cannot fail, then remember that we did come very close to a default of US Treasuries in summer 2011. If the US government defaulted, how would your portfolio look like? Would you have real assets like real estate, infrastructure or commodities that could retain their value in such an extreme event?

But while I advocate considering portfolio sizing as well as portfolio diversification, don’t fall into the trap of optimising your portfolio for extreme events as some market gurus would want you to. Always remember that there are so many gurus because charlatan is so hard to spell. 

Instead, the virtuous investor should create a portfolio that is both well-diversified and well-sized by starting with a simple equal-weighted portfolio. If you put the same amount of money into each asset class and within each asset class the same amount of money into each region or sector you automatically create a well-diversified exposure to different risk factors and make sure that no single risk factor has an extreme influence on your overall portfolio. There are so many studies that show that such equal-weighted portfolios do extremely well in practice that for most retail and private investors they are a great way to invest. Of course, one can do better as I have shown many moons ago in this working paper, but the techniques to beat an equal-weighted portfolio are typically only available to professional investors. And even so, it is not clear that these techniques will outperform an equal-weighted portfolio in the real world with all its unanticipated surprises.

Remember, the virtuous investor treats each fight as if it was her last not by going all in, but by first making sure, she survives. Because otherwise, the fight really could be her last.