Two (Or More) Paths Diverged
Vol #94: August 19th, 2022
When you find yourself in a yellow wood, we’re told, taking the path less traveled makes all the difference.
This New England folk wisdom is timeless advice for voyagers on the journey of life, observing the grassy wear, and pondering which of two roads we should take. The route we choose at each of these junctures helps define us, and every new decision point is an opportunity.
Just as the vines that fight hardest in sandy and rocky soil produce the most select fruit, character is built through overcoming adversity. The less traveled path makes us both resilient and interesting.
That’s not true for your investments.
The path your portfolio takes matters greatly, but the objective is the opposite. Unlike wine or future leaders, the least strenuous path that takes you to your destination is the objective.
When evaluating different outcomes, either of a single trade or a portfolio manager's track record, it’s important to see not only the end to end results, but how they got there. Every future allocation is opting into the results of a specific process.
You can make bad decisions and end up in the right place, and make good decisions and end up in the wrong place. Two people can make opposite decisions and have the same outcome, and the same decisions can lead to different outcomes.
Investors love to talk about different choices they could have made, because the villain or the opportunity is always evident in hindsight. Good investors know they need to not just look for patterns, but hone their decision making process. It’s easy to say you’ll buy the dip, but it’s hard to raise your hand on June 17th when major indices hit their recent lows.
A good process will usually net good results over time, but can produce bad short term results. A bad process can produce short term winners, but will not endure. It’s hard to tell the difference between these two sometimes.
With a simple covered call trade, the investor who is long stock and short out of the money calls can see many different things happen during the course of the trade. If stock drops a little bit early on, the marks will look bad because there is still time value in the short option, but stock is losing money. If stock rips up early on, you’ll mark a winner on the stock, but have to also wait for the short option to lose its value to collect your full winnings.
The ideal path for this trade is a slow and steady trickle up to your short strike. If it rips up, drops down, or maybe does both, you’ll have the same end result, but your account will have seen much bigger swings.
Those bigger swings are likely indicative of a process that might need some tweaking. A covered call is long delta and short vega, so if you’re seeing either stock going down or volatility higher than expected, both those selection criteria *may* be lacking. Better stock picking, vol levels, or strike selection would all be areas to investigate.
Taking this analogy further, if you’re comparing two covered call portfolio managers, you’re ultimately looking for someone with good processes in place to make future decisions. Imagine you’re reviewing results from the first half of the year, they both have similar PnL down 10%, but slightly outperforming the market as you’d expect from a long stock position offset by some premium collection.
If the first manager had 5 months of positive returns, with one big drawdown, and the second had 6 months of consistently marginal returns netting to down 10%, which one sounds better?
For a portfolio manager, I think most people would prefer the second manager with consistently marginal returns. Given the market benchmark, they’re outperforming in line with what the strategy expects. The first portfolio manager making consistent money with a blowout seems dangerous, because that smells like a strategy that’s picking up nickels in front of a steam roller.
It’s a hard question though, because if I was looking for a market maker - depending on the texture of that 1 month - I think I’d pick the first manager. If you’re generating consistently steady returns over many trades, and then have one blow up (assuming it’s a reasonable unknown), odds are there’s a process that can be honed and risk management bolstered. Consistently middling in that scenario probably means lack of edge in their process.
The best path is dependent on the terrain. For most investors that terrain is retirement, and using their wealth to fund their goals. It’s perfectly reasonable to “pay up” for smoothed returns in the form of forgone upside.
I’ve made the comparison before to a plinko board and return distributions. In theory over many iterations, the distribution will fall into place, and arithmetically it’s optimal to have high volatility investments over a long duration. But most of us only get one drop, and it’s really important to nail it.
Absolute returns are so compelling because they are the only thing that consistently maps to the ongoing expenses of life. It’s why we’re drawn into safe sounding investments that promise to push the frontier of risk and reward. Too big of an imbalance here and you’re likely looking at a scam.
Our greedy selves are so naturally swooned by the potential of easy money. An important part of market maker training is repeatedly hammering in the question “Why me?”, as in, if this trade is so good, why am I seeing it?”
As we pick our investments at each juncture - whether that’s a biweekly 401(k) contribution, house purchase, or fund selection - understanding the underlying process is framing your path.