Introduction:

Decades ago, I took a finance class at the University of Michigan and vividly remember when the professor told us that the proper measure of risk is volatility. While I didn’t have the knowledge at the time to challenge the professor, I instinctively and immediately thought that this was incorrect. The only circumstance where volatility matters is if you have to sell an investment at a bad time, and the circumstances where you’d have to sell would be that exact “bad time”. My thought both then and now is that the proper measure of risk is not short-term price fluctuation; but rather, the permanent loss of capital.

 

I believe people focus on volatility because it’s something they can measure and quantify. Earnings estimates can be debated. Discounted cash flow models depend on your inputs and your expected cost of capital. Revenue projections, the competitive environment, and the regulatory constraints are all subject to revision. But volatility offers the certainty of a quantified calculation. We can measure it. We can compare it to our realized return and calculate a Sharpe ratio telling us whether we’re earning a higher or lower return per unit of volatility.

 

Why Volatility is the Wrong Measure:

This focus on short-term volatility is a bad approach. When you buy shares in a company, you’re buying both a stock and a business. The stock market can have a temper. At times, it’s so euphoric that even bad news leads to rising valuations. (The expression is climbing a wall of worry.) At other times, everything gets sold including the great business you own. In the long-run, you own a business, and if you can find high-quality high-growth ones that are well-run and not too expensive, you’re going to do well over time. At DKI, we’ve had more positions rise by 100% or more than we’ve had positions that have lost money. That’s hard to do which is why we run a high-conviction concentrated portfolio. At both Silver Arrow, with my partner, Raji Khabbaz, and at DKI, we’ve always been willing to trade short-term volatility for long-term returns. At both places, we’ve succeeded.

 

Long Term Capital Management:

The Nobel prize winning economists who did the work on volatility and risk were also the same people who founded and managed Long Term Capital Management (LTCM), the firm that blew up so spectacularly they required Wall Street firms to finance a bailout. The problem with their approach is they tracked historical volatility and convinced themselves that huge amounts of leverage was “safe” because they had measured the risk. The approach worked until there was a market dislocation which caused volatility to spike. There’s an old Wall Street expression that markets take the escalator up and the elevator down. That means that rising prices tend to be orderly and falling prices during a crisis, dislocation, or company revaluation tend to gap down hard.

 

In the case of LTCM, prices fell, volatility spiked, and liquidity evaporated leaving the firm unable to sell its leveraged positions fast enough. They were in business for a few years and claimed that the event that killed the firm was so unlikely that it should have only happened once in multiple lifetimes of the universe. They were wrong. More than a quarter of a century later, the fund allocation business still uses this failed model because it allows them to quantify a measure of “risk” and report to investors that they’ve modeled it and thus earned their fees.

 

How to Think About Your Portfolio:

Too much leverage is dangerous and the volatility calculation that many use to “analyze” their portfolio risk doesn’t work when there’s a problem. When there’s a problem is exactly when you’re forced to sell. For most Americans, the most valuable asset they own is their home. Housing prices rise and fall over time, but families aren’t revaluing their balance sheets based on local comparable prices every month let alone every day. People have a general idea of where the market is and may refinance or get a line of credit at times when they have a lot of equity or when they need money for something important. For all the headlines about carnage in the housing market in 2008, most homeowners were fine as long as they owned the home they were living in, could afford the mortgage they had signed for, and didn’t need to sell immediately. It was the people who needed cash NOW, the people who counted on refinancing to afford their current mortgage, and the people who had bought five properties to list on Airbnb and were over-leveraged to a falling rental market who suffered.

 

Your tl;dr* version:  As long as you don’t need funds immediately and haven’t over-leveraged yourself, short-term volatility isn’t important.

 

Private Investments:

This brings me to the private investment / private credit market. These investments have been marketed to the family office community for a long time. The pitch tends to be that these are high-quality high-return opportunities being offered only to wealthy people. Part of the marketing is typically that these investments will have superior returns with lower risk. The lower risk part means low-volatility. The key point is that even if you accept the premise that low-vol means low-risk, these investments aren’t low-vol.

 

Because they’re private investments, there’s no regular market check on valuations. An honest fund that manages these private investments will keep an eye on other comparable private transactions and update their valuations up or down accordingly. However, these same funds collect fees based on assets under management and raise assets based on returns. They have every incentive to treat valuations as a rachet where good news causes upward revaluations, but bad news is ignored. This is something we’ve all seen in the recent private credit market where firms like Blue Owl had investments that were failing, but didn’t mark their book down as conditions deteriorated. The revaluations in their portfolio tended to be from marks that went directly from almost 100% straight to zero. (escalator up and elevator down)

 

The true value of private investments is actually more volatile than publicly traded equities because there’s a lack of liquidity. Blue Owl and other private funds have thrown up gates and not allowed investors full redemptions. They are contractually able to do this. It’s part of the agreement that investors signed. It also makes sense because it’s impossible to run a private fund of illiquid investments and provide investors regular liquidity. Everyone needs to agree to a shared time-frame for the investment to work.

 

So, if private funds and private investments are marketed as low-volatility, then why am I saying that these investments are actually higher-vol in nature? The difference is due to the ability to calculate daily changes in the market. Imagine if you went to a meditation retreat for a month where electronic devices were prohibited. Your stocks would still trade. Their valuations would move every minute the market was open for that month. From your point of view, you now have a low-vol portfolio because you aren’t able to check prices constantly.

 

Your tl;dr version:  The inability to check the market price each day doesn’t mean your portfolio is low volatility. It just means you’re not looking or can’t look very often.

 

Did I Make Money? A Personal Example:

On a personal level, I just made an investment in a company at the very edge of possible technology. It will have a binary outcome. The investors will either make many times our money, or will receive zero back from our investment. We all understand this outcome distribution and have sized our investments accordingly. There’s an interesting quirk of timing with this deal. The founders are doing two capital raises at the same time. The one I’m participating in this week has a designated valuation. The one that might close later this year will be at double the valuation.

 

Imagine that I invested $100,000 and the company closes the second round of financing at the higher valuation in three months. Did I just make $100,000 in one quarter? A private equity fund could reasonably argue that I invested at one valuation and the market was assigning a higher valuation for a subsequent round. They’d mark their book up 100% and would have reason to do so. In this case, I’m not so sure. It’s a private investment. I can’t sell it.

 

The real valuation in this case is likely to turn out to be either zero or millions of dollars. Until there’s liquidity, I can’t open Schrödinger’s box. The cat might be alive or it might be dead, but there’s nothing I can do about it. One might argue that I should mark an investment I can’t sell at zero until there’s liquidity. We could just as easily argue that I should make an estimate about its future value, discount that back, and mark the investment at $200k, or $500k, or $1MM. Whether I tell myself this investment is worth more than I paid (which feels good) or less than I paid (which feels bad) doesn’t matter because I can’t spend the money.

 

Whether I’m honest with myself when I mark my personal holdings is unimportant. When university professors misinform students about the nature of risk is well-meaning nonsense. When private funds mislead investors about the value and safety of their holdings, they’re committing fraud.

 

*tl;dr is short for too long didn’t read, but thank you for making it to the end of this piece.

 

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