In the real world, things happen both inside and outside of your portfolio that “force” you to sell.
One major cause of this is the existence of uncle points; there may be a certain % loss that you are simply unable to bear – mathematically, financially, or emotionally. No matter how good of an investment X is in the “long-term”, if it hits a certain drawdown limit, you may be forced, mathematically, financially, or emotionally, to liquidate your position(s). This could be either as part of the execution of a “financial plan” that your “financial adviser” has thrusted upon you or simply a rash decision in a moment of red-number-induced panic.
But it’s not just in-portfolio events that can result in this phenomenon. Shit happens, causing earlier-than-planned sell-offs and potentially severe losses on investments that you’re “holding” for the “long-term”.
Your returns are heavily influenced by when you sell. You might not be in control of this sell time.
What can we do about this problem?
Unfortunately, not investing in anything at all is not a viable solution, because inflation eats away at your hard-earned cash leaving you with negative real return. Granted, that pile of wonga stored in that obviously-behind-the-painting safe in your master bedroom will maintain its nominal value of £193,520.20 when the financial shit is hitting the financial fan but this doesn’t factor in the certainty that fredos will be £17.99 in 2027. Cash decreases in real value as prices increase, resulting in a negative real return.
One might suggest simply sticking to one’s financial plan. There might be some combination of mind-numbingly-predictable lifestyle plus psychopathic financial discipline that means unplanned liquidation is an unlikely scenario. But even then, unforeseen events (such as global pandemics) can ruin the party.
Note that this wouldn’t be a problem if financial assets only went up; if one only received a positive real return once invested. Although this is not true for individual assets, it might be possible to construct a portfolio that generated positive real returns in over 95%+ of time periods. One could try and construct this type of portfolio as another possible solution to the unplanned selling problem. I wouldn’t really care if I had to liquidate my portfolio suddenly if I was near-certain that this would result in a positive real ROI.
Diversification doesn’t work
“But wait, Haydn, hasn’t this type of portfolio already been constructed? We just diversify, right?”
Not really. Diversification techniques like 1/N, 60/40 portfolios, Modern Portfolio Theory, etc. fail to take into account that all assets seem to become uncomfortably correlated in a downturn. This is a little controversial; some believe that this phenomenon is a statistical mirage, or that it’s only true in some circumstances. But confirmatory evidence is stronger, especially in the academic literature.
And this makes sense.
The global economy, and financial markets by extension, are becoming increasingly interconnected. A sharp sell-off in OATs can trigger panic in the FR40, worrying Raphaël and Jean-Jack Dupont-Dubois at the Deutsche Bank trading desk in London, causing the liquidation of several exotic derivative positions, affecting various other derivatives positions at the Deutsche Bank US headquarters in New York, etc. So when one asset starts to tank, others decrease in value leading to yet others decreasing in value, etc.
The theory used to be that a sell-off en masse would trigger a re-allocation into “safer” assets, such as government bonds. However, increasing mistrust of institutions and governments combined with pathetic bond performance has made re-allocation into these types of assets an unattractive proposition. Why purchase a government bond yielding 1% when I can just wait it out in cash for a few years?
Diversification just doesn’t work in the short term. What we really need is direct hedges. Derivatives that are specifically fucking designed to perform well no matter which assets are rising/falling. But even if this derivative was possible to construct, I doubt it would be accessible to retail investors.
Derivatives and averages
Some hedge funds may have a pitch similar to this type of payoff structure but that doesn’t mean one should invest all of one’s available capital in these funds. A pitch is one thing, strong results for the last few years is better, but consistent results for 20+ years in the future is another thing altogether. Hedge funds suffer from the usual problems associated with active management, in fact they seem to be particularly bad offenders.
Even if some fund could prove it would deliver positive real returns 90%+ of the time, you still might lose.
Take the following returns for a 10 year period, for example: [1%, 2%, 3%, 2%, 6%, 2%, 10%, 1%, 5%, -27%]. Looks pretty good, right? Bit of a hiccup at the end but overall not bad. After the first 9 years an investor would enjoy a total return of 36%, (arithmetically) averaging over 3.5% per year. Even including the final (brutal) year, the arithmetic average of returns would be positive (0.5%). However, the geometric average of returns would be negative. This is the return that actually matters: including the final year, the investor would actually experience a negative return for the period. They would lose money. That is despite the fact that the portfolio had a positive “average” return and a positive return 90% of the time.
Alas, I fear that positive real return across all time periods might not be possible. Markets are somewhat efficient: if this trade existed and was known, maybe more and more people would jump on the bandwagon and the positive real yield would be quickly eroded. It depends if there is a significant market for small but near-guaranteed positive real return. Pension funds, for instance, might be interested in this trade.
Retail investing, as is life, is about trade offs. You may be able to sort of guarantee positive returns over a long time period, but this comes with the inflexibility costs associated with holding for a long time period. You may be able to make 100% return on a single trade, but this comes with the possibility of going to 0. You may be able to collect positive real returns 95%+ of the time, but this comes with either tail risk or an effective upper-limit on returns (or both).