Don't Fear the Reaper
February 23, 2014·0 comments
The categories we use to organize investment portfolios are convenient lies. A technology stock labeled "Value" may share almost nothing in common with an industrial stock labeled "Value," yet they sit in the same portfolio bucket. The appearance of diversification masks dangerous overlap. When markets shift in structural ways, traditional portfolio organization fails not because the model needs refinement, but because it was built on the wrong foundation from the start.
• The language we use to classify investments bears almost no relationship to how they actually behave. We sort by asset class and style box, treating these as meaningful categories. But genetic science reveals that external appearance is a terrible predictor of fundamental difference. Two large-cap value stocks may be genetically identical in their return drivers, while a value and growth stock in the same sector could be fundamentally different.
• Correlation between asset classes is not stable or knowable in advance. It shifts based on political regimes, social forces, and economic structures that cannot be captured by any single model. Bridgewater's risk-balanced approach tries to solve this by looking at macroeconomic regime, but that's just looking at a bigger external appearance.
• Structural breaks happen when lower-level "turtles" shift. For 2,000 years interest payments on corporate loans were illegal. Mortgage-backed securities didn't exist in any meaningful form before 2001, became a $4 trillion market by 2007, then evaporated. These shifts are political and social, not economic, and no model predicts them.
• Model-driven portfolio construction creates a blind spot that cannot be fixed with better modeling. The risk is not that your model is wrong. It's that all models assume bedrock facts that might suddenly change. If you're trapped inside a model's logic, you cannot see what's happening outside it.
• The only constant we can rely on is human nature. Fear, greed, and how people think and communicate about investments are the actual drivers. Building portfolios that respond to emerging patterns in real time, rather than fitting data to predetermined regimes, is now possible with Big Data. The question is whether investors will abandon the comfort of deterministic models to embrace fundamental uncertainty.
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DISCLOSURES
This commentary is being provided to you as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. Epsilon Theory will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results.
Statements in this communication are forward-looking statements. The forward-looking statements and other views expressed herein are as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Epsilon Theory disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein. This information is neither an offer to sell nor a solicitation of any offer to buy any securities. This commentary has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Epsilon Theory recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives.
