Two of The Most Important Concepts That You’ve Never Heard Of - Right Hand Skew and Tail Risk
Regardless of your investment goals or preferences, there are 2 key investment concepts that should be at the core of any successful investment thesis and chances are that you’ve never even heard of either of them. These 2 investment principles are at the center of our own investment strategies and could be the key to unlocking attractive risk adjusted returns for your own portfolio.
However before we can delve too deeply into these two concepts let’s take a step back and examine how most people look at the risk and return characteristics of a portfolio. In traditional financial theory most portfolio returns are modeled as a normal distribution I.E periods where portfolio returns are very poor are highly unlikely and similarly years where portfolio returns are very strong are equally as unlikely. Under a normal distribution then the majority of returns then are concentrated around the mean which for the ASX200 we will assume to be around the 8.4% mark which according to Vanguard was the average rate of return from Australian shares since 1 July 1987. However as anyone with even a modest amount of investment experience will know portfolio returns are very often dramatically different from this 8.4% mark. 2011 for example saw an -11.4% drop or an almost 20% deviation from the mean whilst 2008 infamously delivered investors a return of -40.4% which is almost a 50% deviation from the mean. On the upside 2009 saw a 39.6% gain whilst 2013 saw share prices jump 19.7% both of which represent significant deviations away from the mean. With so many years of outlier returns in just the last 10 years alone it becomes clear that the normal distribution is perhaps not the best means to model the behavior of stock market returns.
A better model would be one which can accommodate for the high probability of these outlier events and realizes that most returns are in fact not centered around the mean – Enter the fat tail distribution. The fat tail distribution looks much like a normal distribution except as the name suggests the probability of outlier events occurring at both the right (positive) and left (Negative) end of the probability distribution are far greater than is under a normal distribution.
So now with a more realistic view of how the stock market behaves the logical next step is trying to understand how we can use this knowledge to our advantage – Enter our first key investment concept the right hand skew. A right hand portfolio skew simply means that your portfolio is more likely to experience returns on the right hand side of the fat tail distribution I.E positive “outlier” events. Creating this right hand skew however is easier said then done – At a practical level it involves identifying stocks which exhibit certain characteristics which have historically produced very strong returns. It also involves having an understanding of where your portfolio is generating its returns from an maximizing your exposure to these assets. This is in stark contrast to a dynamic asset allocation which seeks to maintain a set % allocation to certain stocks, industries and asset classes. The flaw of such an approach is that it fails to recognize that portfolio returns are largely derived from the top quartile of performers in a portfolio I.E the assets generating the outlier returns. Failing to recognize how your portfolio generates its returns means you are constantly selling your winners and buying your losers which all but ensures you fail to create this coveted right hand skew.
However understating the fat tail distribution not only allows you to maximize your gains on the upside it also allows you to minimize your losses on the downside by controlling your tail risk which is t second key investment concept. Tail risk and more specifically left tail risk refers to the risk that your portfolio produces a return far out on the left or negative side of the distribution like we saw in 2008 where markets declined by over 40%. Understanding that these periods of poor market performance occur somewhat frequently and positioning your portfolio accordingly is the key to defining against these large market declines. We’d argue the best ways to position your portfolio to minimize your tail risk is by switching to cash when bearish conditions start to prevail (Or investing with a fund manager who has the ability to switch to cash in poor market conditions). Blending in allocations to alternative assets which have low or negative correlations to equities can also be an effective means of smoothing out your portfolios overall performance.
At Harbourside Capital all of our portfolios are constructed with the intention of creating a portfolio that has a strong right hand skew and minimal tail risk. From that tail risk perspective, we look at how our portfolios performed during the GFC as a testament to how we were able to manage investment risks in those outlier left tail events. From a returns perspective we think our long term performance tells a better story about how we have been able to create a return profile heavily skewed to the right hand side than we ever could.
Source – Vanguard, Market Index
HarbourSide Capital Pty Ltd (ACN: 166 765 537) is a Corporate Authorised Representative (CAR No. 448907) of HLK Group Pty Ltd (ACN: 161 284 500) which holds an Australian Financial Services Licence (AFSL no. 435746). Any information or advice contained in this article is general in nature and has been prepared without taking into account your objectives, financial situation or needs. All securities and financial products or instruments transactions involve risks. Past performance is not an indication of future performance.