Saturday, January 25, 2020

Expectations differ by generations - How do you deal with generational financial experiences?



  • If you grew up during the Great Depression, you are always expecting the next Depression.
  • If you were an investor during the Great Inflation, you will always be worried about the next great inflation.
  • If you were a big investor during the Great Financial Crisis, you will also be worried about another crash.
I think you get the idea. There are generational events that will drive market expectations and behavior. The big events are usually negative because they are usually a surprise, occur over a short time, and cause significant anxiety. The big events have an imprint on our behavior through the availability heuristic. We then look for confirmation of events that these negative events will occur again. Some of these expectations will only change when that generation dies off, or in the case of investors and traders, no longer represent the majority of assets. 

Risk aversion is related to a number of investor specific characteristics: 
  • Associated with lifetime experiences - Did you suffer or profit from a bad event (Financial Crisis, mortgages, tech bubble, LTCM, emerging market failures, etc...)?
  • Associated with age - Did you investing life-cycle include these events? 
  • Associated with past losses - Did you lose money in last crisis?
The challenge is learning to look beyond rare events, yet in reality, you cannot look beyond them because they have occurred. They are not possibilities but represent reality. Big tail events are a part of finance. We can minimize the look-back period to eliminate these outliers, but it does not change the fact that big negative tail events have occurred. 

The challenge for building any portfolio is identifying and overcoming potential biases based on these generational tail events that may not be as relevant in the current environment while at the same time accounting for reality. Some of the poorer performance of hedge funds may be associated with a decreased willingness to take risk given the tail events of the past. The closure of some funds may be associated with the manager's inability to reconcile his historical experience with the realities of today. The scars of the past bind the present.

Rare events should not be discounted to zero but have to be given their appropriate weight. Unfortunately, the weight for rare, but substantial events, is not a problem that is easy to solve. It is easy to say, give those tail events their due, but they may never occur again in an investor's lifetime. Yet, not accounting for them may generate financial ruin; the intersection between black swan theory and black swan failure.

Perhaps the greatest risk management issue is determining how to properly measure the uncertainty of low probability events of financial failure over a set horizon. What is the likelihood of a 50+% stock crash in the next three years? There are formulas to calculate likelihood given past crashes over some historical sample, but small changes in the problem set-up or looking at a shorter sample of history will give very different answers. More importantly, how should investors respond to different likelihoods of rare events? Should your behavior change if failure moves from .005% to .02%? 

A simple response is that it does not matter much because an investor should always protect against any event that has a minimum tail likelihood. Still, the response of what will be done with this information could be radically different based on who is receiving the information. 

Perhaps every firm should have a wide set of ages and experiences on their investment committee to offset or diversify generational event risk perceptions.   

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