3. What Risk Control to Run?

“It’s not what you don’t know what kills you; it’s what you know for sure and is not”.

—Mark Twain

The third key element to any strategy is to add the necessary risk control. It is inevitable that the individual components of the Austrian Portfolio, as classic asset classes, to suffer deep and prolonged losses —their ‘bear markets’— producing painful drawdowns. The task of risk management is to protect and preserve the wealth of the investor, limiting those losses that every asset suffers across the evolution of the economic cycle.

In order to achieve that, one must be extremely careful when modifying in some way an always invested well-diversified portfolio as the Austrian Portfolio.

The reasons and tools employed have to be —in the same way as answering which assets and which asset allocation to choose— empirically persistent, ubiquitous and also driven by the nature of the environment. In other words, it is the nature of markets which will decide what type of risk control to use in the Austrian Strategy.

Convex Strategies for Unpredictable Markets

Any specific investment strategy can be broken down into only two families of strategies; concave or convex. As Nassim Taleb profusely explained in his Incerto work; it is the nature of the medium —in our case, the economy and the markets— that determines which type of strategy will be the more suitable to survive and thrive in it. In deterministic and predictable environments, concave strategies are the most appropriate. But in non-deterministic and unpredictable environments such as financial markets, the most appropriate type of strategy will be convex.

In short, a convex investment strategy always limits the size of the losses while allowing the winners to run with no limit. It assumes that mistakes and losses are going to be the most likely outcomes since we cannot predict the future. Over time, this produces a positive asymmetric distribution of returns when the underlying asset class has an intrinsic long term growth component —as is the case with the classic asset classes that the Austrian Portfolio includes. This is also one of the main reasons indexes perform so well over the long term.

To choose a risk tool and use it convexly, it is necessary for that tool to be persistent. Tools based on past statistical descriptions or properties such as Markowitz Optimization, Risk-Parity,  Value-at-Risk or any statistical mean-reversion will not be used, as all concave strategies should be rejected by the Austrian Investor —as they provide false confidence and a misleading sense of security.

The most persistent and strong investing factors are Value and Momentum. Being value a way to pick stocks, momentum can be used both for chasing returns (as many funds do) or as a risk tool.

In the Austrian Strategy, momentum is used as a risk tool, not as a way of trying to increase returns in any sophisticated (and consequently riskier) way. Risk control is about limiting deep prolonged losses and the Austrian Investor must know that trying to outperform the natural rate of markets returns is a reckless game.

Momentum as a Risk Tool

Reasons to use momentum as a risk tool:

  1. Momentum is the strongest and most persistent factor-based investing identified: a millennial phenomenon always present across all markets, in all different cultures and at all times.
  2. In order to be coherent with the Austrian agnostic position regarding (useless) predictions, momentum is a reactive, not predictive, tool.
  3. I believe momentum will be persistent in all futures markets because it is rooted in the nature of human beings. The reason is that we are all born with a brain (our ‘personal hardware’ to process the world), subject to its evolutionary biochemical and cognitive limitations (our “Operating System” and “Apps”) inherited from our ancestors, producing emotions such as fear and greed that biases our judgment. It is implanted deep in our nature and very difficult to overcome or control (hence the importance of a Stoic behavior when investing). As long as the economy is a byproduct of human action, there will always be cycles in the Economy and momentum on the markets.
  4. Momentum allows a convex implementation —cutting losses short and letting profits run—, suitable for unpredictable environments as financial markets.

It is important to emphasize that the Austrian Strategy does not choose which assets to invest in at any given time, rather it starts from the basis that all assets of the Austrian Portfolio must be invested in (in order to cover all possible economic states without any forecasting). Then the risk management is to simply reduce the bear markets that occur in the classic asset classes during their typical market evolution through the Business Cycle, allowing the positive returns of the remaining assets in the Austrian Portfolio to capitalize the cycle in a natural way.

Implementation of Momentum as a Risk-on Risk-off tool

Besides the intrinsic limited exposure to each asset class in the Austrian Portfolio (25% each asset class) and the fact that indexing (through ETFs) is in the long term a convex strategy in itself, the Austrian Strategy increases the convexity by adding my proprietary risk control metric based on momentum as a risk tool:

Austrian Strategy = Austrian Portfolio + Risk Control (momentum)

The risk management consists of a Risk-On Risk-Off dynamic risk control applied independently for each asset in the portfolio as follows: If the asset being evaluated shows a negative absolute long term momentum (by itself, not compared with others as relative momentum does), then its position in the portfolio is sold entirely and allocated entirely for safety to US Intermediate-Term Government Bonds (in a binary way), until it ceases to show negative long term momentum and re-enters in the portfolio.

In other words, starting with the fully invested Austrian Portfolio, only assets with negative long term momentum are excluded from the portfolio, avoiding the main part of their deep and prolonged losses, while leaving the remaining asset classes in the portfolio to capitalize on the given economic scenario across regions.

Every month the Austrian Portfolio will be evaluated this way and any change will be reflected in the Newsletter sent on the last market day of each month, so the subscriber can comfortably execute the changes on his own account.

Capitalizing on tides, not waves

It is important to understand the dynamics of momentum as a medium-term risk tool. As any reactive (non-predictive) tool, momentum will not precisely capture market bottoms and tops. But it is sensitive enough to capture the Business Cycle —the ‘tide’ of the economy—, avoiding the main part of assets’ bear markets and allowing to monetize the bulk of bull markets over time.

As a medium-term dynamic risk tool, it doesn’t react to short-term changes in the market. The Austrian Investor has to be aware that the Austrian Strategy capitalizes on the tides of the economy, not waves or splashes (as the noisy daily news). An example of the Risk-on/Risk-off risk control applied on Gold:

The chart shows that despite the wrong signals, applying a momentum-based risk control allows capitalizing on gold bull markets (2002-11), while staying out of the main part of bear markets (2013-15). Similar results are achieved with the rest of the classic assets in the Austrian Portfolio.

Specific risks and drawbacks of momentum as a risk tool

As explained above, no management tool can be perfect when the environment is non-deterministic. Therefore, the investor must be aware of the properties that this type of management will produce in order to be able to manage it emotionally:

  • As a medium-term dynamic risk tool, it doesn’t react to short-term changes in the market.
    • Random daily news does not change the course of the economy overnight. It takes months to actually change the state of an economy. The Austrian Strategy is conceived to capitalize and protect over the Business Cycle —the “tide” of the economy—, not to react to the noise of the daily news —the “waves and splashes”.
  • Expect some volatility but mild drawdowns. There is no perfect strategy without some volatility and drawdowns:
    • The largest monthly drawdown to date of the Austrian Strategy was -9.31%.
    • Annualized monthly volatility can vary from 3% to 12%, with a long term average of 7.51% (currently at 4.92%).
  • Periods of underperformance
    • As a long-only strategy, when there is no asset providing positive returns, it will be difficult for the strategy to provide positive returns as it happened in 2018 (no mayor asset class provided positive returns in 2018).
    • Depending on specific market conditions, it is possible to underperform the always invested Austrian Portfolio for some time. However, a passive always invested portfolio doesn’t protect against the bear markets of its components (i.e. the year 2008). Eventually, the economy ends up strongly polarizing itself on a clear state (we don’t care which), so the Austrian Strategy capitalizes the economic cycle with similar long term returns but with much less risk of an always invested portfolio.
  • Asymmetric payoffs: In the long term many small losses are compensated by a few but large gains.
    • Over the long term, investors must be prepared to see a majority of losing trades (although by a yearly limited amount as the strategy only trades once a month), while winning trades should more than makeup for that.