There’s nothing like a crisis to bring foundational investing principles to the fore. They lay all my triumphs and tribulations bear for me to see. Evasion is no longer possible. Assumptions, rationalizations, and truths are crystallized as profits and losses. This turbulence, though, is a crucible for learning. For me, the past few months illustrated how collateral, leverage, and volatility interplay to drive investment performance. I see them as the “what”, “how”, and “when” to invest, respectively. So much of investing is focused on what to buy. Valuation, factors, price, and trend get all the attention. Naturally, the investments selected and the idiosyncrasies of the economic landscape drive performance. But as Daniel Want, the Chief Investment Officer of Prerequisite Capital
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There’s nothing like a crisis to bring foundational investing principles to the fore. They lay all my triumphs and tribulations bear for me to see. Evasion is no longer possible. Assumptions, rationalizations, and truths are crystallized as profits and losses. This turbulence, though, is a crucible for learning. For me, the past few months illustrated how collateral, leverage, and volatility interplay to drive investment performance. I see them as the “what”, “how”, and “when” to invest, respectively.
So much of investing is focused on what to buy. Valuation, factors, price, and trend get all the attention. Naturally, the investments selected and the idiosyncrasies of the economic landscape drive performance. But as Daniel Want, the Chief Investment Officer of Prerequisite Capital Management, puts it:
“Throughout different times in history, what is considered a ‘collateral’ asset can change, in some circumstances collateral could mean cash, or certain currencies, or treasury bonds, or gold, or commodities, or real estate, or even certain types of equities at times. You just have to simply ask yourself… in light of how the system currently is structured and working within view of the predominant issues, (1) what things would rise with conditions of ‘growing confidence’, and (2) what things would likely rise in conditions of ‘growing demand for collateral’ (& collapsing confidence)? At different points in history you will answer very differently to these questions.”
Daniel Want, Prerequisite Capital Management’s July 14th 2019 Quarterly Client BRIEFING
As Want points out, there are factors other than “what” to consider when investing. How to own your exposure and when its best to do so are just as impactful. Want sees these as matters of collateral and confidence. For me, viewing investments through the lens of collateral, leverage, and volatility provides this perspective.
I see collateral as the foundation of investing. Collateral are things directly exchangeable for currency with a direct use value. The value can be for consumption—like wheat; for accumulation—like a bond (i.e. a contractual stream of cash flows); or have intangible value, like a trademark. Even cash is collateral since its utility is to mediate exchange.
Collateral are assets in the most basic form. It’s the “what” in investing. iPhones, sneakers, advertising slots, computer code, electricity, transportation, cloud storage, and even people’s attentions are all types of collateral. They are the goods and services that we trade for every day in society. As investors, it’s collateral’s value that we ultimately seek exposure to and on which we speculate.
However, most collateral sits outside the realm of financial markets. It’s simply inefficient to buy a bunch of smartphones and sell them overseas to a clamoring population. Thus, we rarely cross paths with collateral in a pure form in the investment markets. More commonly, we find it in the presence of leverage.
Commodities provide one clear illustration of this. Each one would constitute collateral on its own—oil, gold, corn, soybeans, pork bellies, etc. However, in financial markets commodities take the form of futures and forward contracts. While we call these commodities, they are actually rights (or obligations) to specified quantities of the underlying asset. In reality, commodity contracts are leveraged exposures to the referenced commodities, and specifically financial leverage.
However, there’s an even more common form of leveraged collateral: stocks! Companies are organizations that profit from creating goods and services. They employ specialized infrastructures calibrated to maximizing productivity. Why purchase a bushel of corn to resell when you can buy a stake in a farm’s entire harvest, presently and in the future? By applying operating leverage—the fancy name for this infrastructure investment—corporations supercharge the value reaped by producing various types of collateral. They can also employ financial leverage (i.e. debt) to compound the effects of their operating leverage.
In our modern society tuned for efficiency, leverage is inescapable. Hence, it’s ubiquitous in financial markets. Financial and operating leverage come in many different forms and in countless combinations from which the investor can choose. In all instances, leverage is the “how” collateral is owned.
In the financial world, volatility describes the price fluctuations of investment values. The more a price gyrates, the greater the asset’s volatility. Thus, volatility is often conflated with risk, as it conveys a range of price movements that an investment experienced or is anticipated to have in the future (depending on the metric used).
While true, volatility in its more conceptual form describes uncertainty. Investment prices are forward looking. They change only when the present view of the future proves to be inaccurate and requires adjustment. Thus, volatility describes the magnitude of error of past expectations. It’s a scorecard of forecast accuracy. The greater the price volatility, the less accurate the market was at predicting an asset’s future price.
In this mental model for investing, volatility is the “when” for investing. Since it relates to price movements, we can use it to determine when to apply leverage and, by extension, in what forms and amounts.
Investing is What, How, & When
It’s easy to see how different collateral types can generate different investment returns. Hence, it tends to garner the most attention. Should I invest in Stock A or Stock B; in retail or technology; in bonds or gold; etc.?
However, how one owns collateral can be just as big a return factor, if not more. The greater an investment’s volatility the more leverage impacts returns, positive and negative. The profit from the same $100 rise in the price of gold will be different for a $1,000 investment in gold coins, gold futures contracts, and a gold mine (with unhedged production), all due to leverage. Thus, one’s expectation for gold’s volatility, in this example, should dictate his/her preferred investment vehicle for the desired collateral.
Investing is an act of selection. Buying and selling specific assets is just one piece of the pie. Sizing those exposures according to our convictions in their potential range of future prices is the other. In other words, investing is the combined expression of collateral, leverage, and volatility!
What, How, & When in Practice
It’s one thing to mentally model investing as collateral, leverage, and volatility. It’s another to put it to practice. While sounding abstract, this seemingly has been done for ages, purposely or not.
Scaling investment exposures by volatility is hardly a new idea. Value at risk models are cornerstones in risk management. Strategies like risk parity and vol targeting have been around for decades. In fact, even the “classic” 60-40 portfolio balances collateral, a bond position, with leverage, i.e. equities.
While these techniques all use volatility in a particular way, we need not follow suit. To me, a more logical goal is to coordinate one’s use of leverage with expected changes in volatility regimes. For example, if your maximum leverage coincides with a fall in volatility, you should profit from the narrowing of possible price ranges (if you’re right). Conversely, carrying less leverage when price uncertainty explodes minimizes the cost of error and best positions you to act in the more uncertain environment.
A Mental Model For Investing
What to own, how to do so, and when are some of the most important determinants of an investor’s success. Ultimately, we all rely on some kind of model to invest, whether we know it or not. Perhaps viewing these fundamental questions as matters of collateral, leverage, and volatility can provide a useful framework, and even help us adopt some commonplace techniques to better achieve our individualized investment goals.