There is this current dilemma of how to invest in stormy times (well, it is not a current dilemma, but according to the last 20 years it may look like one).

Financial theory says that in order to take great rewards you have to take great risks. Or to put in other words: Rewards are the compensation for taking risks. However, risk is subjective, not objective. The interesting question is therefore, if we can make „risk“ an objective matter that we can then implement into our portfolio strategy.

Let’s start with risk: We can say that risk means that there is a possibility we will have less liquidity at any given time than you originally expected from our investments. (There are of course a bunch of different types of risk which we will cover some other time – if you are interested…). But in genereal it is the potential for loss, and the scope of that loss.

 

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The Concept Of Expected Return:

 

Expected return plays a large role in financial theory. Although we know it deals with future outcomes, unfortunately many people mistakenly confuse expected return on investment with a hoped-for, desired, or possible return on investment. But expected returns are always only estimates – and are calculated on the basis of different assumptions and/or different time periods. And according to the law of large numbers, the longer the time span, the more accurate this estimate becomes.

People think that expected returns are the result of growth, future cash-flow, or profits. Wrong. One investment A with high profits does not necessarily have a higher expected return than investment B with lower profits. It may have a higher prize, but that argument doesn’t count either: Important is how big the ‚uncertainty‘ about the cash-flow is. The one investment with the higher uncertainty “wins” (is riskier -> therefore higher returns). Because if one day it turns out that these former assumptions about the risk didn’t come true (maybe they have been overestimated), the rising price for this asset is now the return.

Think about such companies as Amazon, Facebook and Tesla when their stocks were costing a low two-digit amount. It was the uncertainty (about the survival and/or future innovation possibilities of those companies that eventually defined the risk – not the numbers of the company per se).

The general conclusion however: There can’t be any return without risk, right?

 

So Much For The (Theoretical) Basics

 

Unfortunately, this theory still relies on one big (undesired) concept: Future “prediction (skill)“ is still involved.

So I’m actually more interested in how successful investing is possible without predictions! To me, that’s the secret of good investing if you will.

In hedge fund manager Mark Spitznagels’ book “Safe Haven” this concept is deeply discussed. But beware: It is not a “how to” book or contains any investment tips. It is for psychology and philosophy nerds like me who want to work on the root and are not interested in a quick buck (which I would have to worry about how to get it the next day, and the day after, and so on – just like in the proverb: Give a man a fish, and he has a meal for a day. Teach a man to fish, and he has a meal every day).

The book deals with the questions such as how we can expect risk mitigation to be cost effective. More importantly: How can we make higher profits with risk mitigation, what is the mechanism behind it, how might we recognize it? While working through these questions, you will get an idea, what a “Safe Haven” actually is – and how powerful the idea is.

To quote the modus tollens (the form of argument in which the consequent of a conditional proposition is denied, thus implying the denial of the antecedent) from the book:

“If a strategy cost-effectively mitigates a portfolio’s risk, then adding that strategy raises the portfolio’s CAGR (Compound Annual Growth Rate) over time.

Adding that strategy doesn’t raise the portfolio’s CAGR over time.

Therefore, it does not cost-effectively mitigate the portfolio’s risk.

What we have here is a natural, testable conjecture about safe haven investing. And it’s important to understand what this hypothesis testing can and cannot do. It can only refute or falsify the hypothesis. If a safe haven strategy does not raise a portfolio’s CAGR over time, then the null hypothesis – that the strategy cost-effectively mitigates the portfolio’s risk – does not hold.
If it disagrees with experiment, it is wrong – it is not a cost-effective safe haven strategy. What we cannot do, however, is prove something is a cost-effective safe haven strategy. Such is the scientific method.”

“All knowledge is a hypothesis; it is all conjectural and provisional, and it can only be falsified, never confirmed.”

Isn’t that interesting? No more spoiler alerts – you will get the answers in the book. Who needs Netflix for an exciting ride? Books reach brain regions that the television can never reach!

You can order the book directly here on Amazon through this affiliate link. There will be no additional costs to you – but it helps me to keep this blog alive.

For more books on finances, see my current suggestions.