The Art of Streetplay

Friday, July 22, 2005

Assumption Management

Regardless of the discipline you practice, be it market neutral quant or deep value or event driven or what have you, it might be of value to think more carefully about assumptions.

To put it simply, if we didn't make assumptions we would probably cease functioning. Investment philosophies necessarily carry with them implicit assumptions; the question then becomes what assumptions are your model making and what impact do those assumptions have on your model's perception of reality relative to reality itself... and most importantly, in what sorts of situations will your model systematically deviate from reality and why? Not fully knowing the assumptions underlying a model that you trade seems to me to be similar to going into battle with a gun that you know nothing about. What happens when the gun jams? This is also very similar to accepting tips from a well regarded friend. He might be extremely smart. Hell, he might be right. But should the investment being tipped start tanking like a stone, it feels like shit. I'm sure you've probably had this happen at least once or twice. I sure have.

If you know how and why your model may not be working as well as expected, you can move to the sidelines and tune your model. If you don't, well, sorry.

Take, for example, a 'simplistic value-biased' investor who each year longs stocks in the S&P whose P/E's are in the bottom decile of S&P stocks and shorts stocks whose P/E's are in the top decile of the S&P. What assumptions is he making in constructing such a portfolio? He essentially is assuming that returns of stocks in the S&P are mean reverting over time conditional on the P/E decile one is in. But is it always that way? Maybe we can shine some light on that assumption by pulling up return data over the past 50 years or so to see how empirically mean reverting returns have been. In some years it may work better than in other years-- can we explain this? Intuitively one would expect a strategy like that to underperform during bubble times (ie. internet bubble). Is there some way we can forecast the occurrence of bubbles? Probably not. What is the worst that could possibly happen? Can we stomach the maximum drawdown? What's the expected return? What's the expected volatility of that return? Is there any way we can improve the risk-reward profile of the strategy? Throwing the model into the real world, do we have to worry about liquidity issues on the short end? Might we get squeezed out, causing the model to deviate from the real world? And these questions probably make me only half comfortable with my fundamental assumption.

Why does a deep value investor buy a stock? Because the stock will go up over time... but why? What assumptions are we making and why do we not have to worry about them?

Assumptions and risk are similar in some senses. When I make an investment, I am exposing myself to a plethora of different risks. Liquidity risk. Mark to market risk. Perhaps counterparty risk. Market risk. As an employee at an investment vehicle, I am also exposed to operational risk. What if my boss dies, leaves, loses his desire to work, or fires me? What if the electricity goes out in my building? What if my internet goes out?

The reason it has been said that derivatives are a good thing is because they allow for more efficient transfer of risk. In doing so, the people who want to expose themselves to more particular forms of risk are able to do so, perhaps making the market more efficient as a result. It's like the deep value investor who gobbles up huge tons of the market's individual idiosyncratic stock risk. They do so because they have thoroughly researched the risks they will be taking on and are in the best position to accept that risk. From a market stability standpoint, this is a good thing.

Managing risk is very important. By managing your assumptions you are managing your risk.


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