Life Finds a Way (Kashkari)

Life Finds a Way

• In this New Normal economic environment of slow economic growth, high volatility and enormous macro risks -- some identifiable, but many unidentifiable -- we don’t believe ignoring major downside risks is prudent for equity investors.
• We believe investors are best served by employing a combination of three strategies to actively manage downside risk in equity portfolios to hedge against the risks they can see, and equally importantly, the risks they can’t see.
• Risk management is often a tradeoff, decreasing some risks while increasing or concentrating others. Being humble enough to admit what we don’t or can’t know is important.

I bought a cabin in a forest high in the Sierra Nevada Mountains in 2005. Surrounded by pine trees and natural beauty, it is a peaceful getaway from busy life. The cabin is fairly remote at an elevation of 6,500 feet and almost 10 miles from the local town. My closest neighbors are deer, birds, chipmunks and an occasional bobcat, coyote or bear.

This is the first and only home I’ve ever owned. Even though it is not fancy, it was a major financial commitment for me – the biggest I’ve ever made. A former engineer, I read everything I could find about the challenges of owning a home in a remote location.

Although it is connected to the power grid, water comes the old-fashioned way: from a well that runs 500 feet underground into a six-foot tall, 2,500-gallon storage tank that feeds the house. My research highlighted the risks that come with being so distant: Septic systems can freeze. Well pumps can go bad. Unlike a typical house, if power gets knocked out, you also lose your water because the pump can’t run.

With all of my research I concluded that these risks were manageable. I even created a checklist of procedures I would follow every time I visited the cabin to manage them, such as shutting off the water when I leave, using Ridex in the septic system every month and checking the water storage tank each visit.

It’s been six years now, and extreme cold winters and power outages haven’t been a problem. With the help of a back-up generator, my vigilance paid off. I considered and prepared for all contingencies.

Or so I thought.

This past August I visited the cabin and dutifully followed my checklist: I inspected the water tank. It was full as it should be. Everything was working fine.

Check.

And then something caught my eye: “What is that in the tank?” I shined my flashlight and squinted closely. “Oh… my…”

Yup. It was a frog, hanging on the inside wall of the water tank just above the water line. Oh, and there was another one. Oh, and there was a third. They were just hanging there – the frog’s equivalent of lying by the pool at a resort in Palm Springs.

I was stunned. Not because I don’t like frogs. I do like frogs: I remember catching and playing with them when I was a kid. Frogs don’t mean harm to anyone, except for the insects they eat. These three frogs were just hanging out, minding their own business, taking an occasional swim, eating a fly from time to time.

But they were hanging out in my water tank! The tank that feeds my house – drinking water, showers, laundry. And who knows how many of their friends were in the tank with them.

The shocking part for me was that I couldn’t figure out how they got there. There is no body of water within miles of my cabin. I’ve seen plenty of animals and insects but have never once seen a frog in this mountain forest. Even if they did live in the forest, how did they find my water tank and how did they climb six feet to the top and sneak their way in the lid? Could tadpoles have been living 500 feet underground and been pumped in? I had flashbacks to the movie “Jurassic Park,” in which Jeff Goldblum’s character tried to explain how a population of all female dinosaurs managed to procreate: “Life finds a way.”

No homeownership book I read ever warned me about frogs living in my water tank. I even Googled it to see if this is a common problem; I couldn’t find another example. With all my vigilance trying to identify things that could go wrong, I simply never conceived of this possibility.

Following the financial crisis of 2008, many people were understandably angry that banks, investors, ratings agencies and regulators all missed the housing bubble. How did they not see it coming? Why didn’t they take action to protect against such a collapse? The rallying cry became, “We need better risk management!”

It is easy to identify risks in hindsight – even frogs living in your water tank; unfortunately it is much harder to identify them in advance, particularly when they had been “unthinkable.” I bought real estate in 2005, after all. I didn’t spot the housing bubble either.

The most sophisticated risk management models can’t protect against scenarios that we’ve never contemplated. Leading up to 2008, most people believed that home prices across America could not fall all at the same time. Bundling mortgages from different parts of the country should have provided diversification against regional real estate downturns. The models were very sophisticated – until the impossible became reality.

Today, with the benefit of hindsight, it is easy to find people who spotted the housing bubble. Michael Lewis’ book “The Big Short” documents some of them. The book would have been far more impressive had Lewis written it in 2005.

Since the crisis of 2008 Washington has been busy passing new laws and policymakers implementing new regulations to ensure the crisis is never again repeated. Like the TSA adding security procedures in response to each new terrorist threat (x-raying shoes, for example), these numerous regulations should be effective in protecting against a repeat of the exact same mistakes. Unfortunately, markets of the future will no doubt make different mistakes. As much as we may try, we can’t legislate wisdom.

Unthinkable events now seem to be happening with increasing frequency: The U.S. losing its AAA credit rating. The euro on the verge of disintegration. Political turmoil in the Middle East overthrowing decades-old regimes. A terrible earthquake, tsunami and nuclear disaster devastating Japan. The complete dysfunctionality of Washington D.C. (Ok, so this isn’t new – but it certainly seems to be worse than ever).

With muted economic growth in the developed world, our economies are highly vulnerable to shocks that could tip us into recession. Policymakers are well-intentioned but are human, make mistakes and often face very real political constraints. These macro risks are overwhelming individual company factors and causing wild swings in the stock market almost every day.

If, despite all our vigilance, none of us can see all the major risks, how should equity investors manage risk in this environment?

Historically, with fewer macro risks on the horizon, most equity investors didn’t do anything about them. Most “self-insured,” which is a fancy way of saying they took no actions to protect themselves against bad outcomes. If markets corrected, such as when the NASDAQ came crashing down in 2000, many rode the correction down. Some got scared and sold low. Others rode it out and hoped prices would eventually rebound. Imagine getting in a car accident and the other driver tells you he is “self-insured.” I don’t think you would find it comforting. Self-insurance didn’t work well for technology investors in 1999.

In this New Normal economic environment of slow economic growth, high volatility, and enormous macro risks -- some identifiable, but many unidentifiable -- we don’t believe ignoring major downside risks is prudent for equity investors. We believe investors are best served by employing a combination of three strategies to actively manage downside risk in equity portfolios – to hedge against the risks they can see – and equally importantly – the risks they can’t see:

1. Buy stocks at cheap prices

   Investors should buy companies they want to own for the long term – and evaluate them in a range of economic scenarios. By buying companies at prices deemed cheap relative to fair value based on rigorous fundamental analysis, you can build in a cushion against market shocks. This doesn’t mean the stocks won’t fall with the next market correction, but it means that unless the macro shock meaningfully changes the outlook for the companies you own, the volatility may just create a buying opportunity.

2. Buy higher-quality companies

   Higher quality companies tend to be more resilient against bad events. They tend to have more effective management teams, stronger market positions and business models that are more defensible. We believe buying higher quality companies at cheap prices provides even greater defense against the unknown.

3. Hedge the portfolio against “tail risks”

   We believe investors should look all over the world for cheap hedges against left-tail events – or really bad outcomes. This could be options on equity indices, or currencies or credit instruments. Consider allocating a small amount to spend every year to buy hedges. Most drivers put on their seatbelt every time they get in their car even though they aren’t expecting to get into an accident. It’s a low-cost way of guarding against serious injury. Most equity investors know they are investing in a relatively volatile asset class. So we don’t recommend trying to hedge all volatility. But hedging extreme drawdowns from major market corrections can be a cost-effective strategy. And because many asset classes tend to become highly correlated during times of crisis, investors should look at a wide range of instruments in an attempt to find the cheapest effective hedges.

After discovering the frogs in my water tank, I upgraded my well pump, eliminating the need for the tank, which I then emptied into the forest. Reducing complexity is a proven engineering risk management technique. Now I have fewer things that could go wrong – but no back-up store of water if something does go wrong.

Risk management is often a trade-off, decreasing some risks while increasing or concentrating others. Although not perfect, being vigilant to identify and manage the downside is important. But being humble enough to admit what we don’t or can’t know is also important. Hoping for the best while preparing for the worst is generally a good strategy.

The frogs probably never considered the possibility that their luxurious swimming pool might one day disappear. Poor little guys. I wish them well.

Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.​