It’s All About Risk
Bruce Schneier, an author who wrote about how we perceive danger, outlined cognitive biases people fall victim to when making decisions about risk (Housel, 2011). Although general in nature, they apply to investing, specifically diversifying, or the lack there of.
- The unknown is perceived to be riskier than the familiar. Schneier's example: "People fear kidnapping by strangers when the data supports kidnapping by relatives being much more common." In investing: The Flash Crash in 2010 caused untold anxiety. Years later, it is still frequently mentioned as a serious risk to markets. In reality, though, it was a non-event. The entire event came and went in a few minutes. Most investors didn't even realize it occurred until it was over and losses were reversed. What made it scary is that it had never happened before and was so unexpected. Meanwhile, the risks posed by the herd mentality of buying high and selling low can be absolutely devastating to long-term wealth -- yet it's culturally acceptable because it's so familiar and prevalent.
- We underestimate risks in situations we do control, and overestimate risks in situations we don't control. Here's Schneier: "Once you take up skydiving or smoking, you downplay the risks. If a risk is thrust upon you -- terrorism is a good example -- you overestimate the risk." In investing: Wealthy investors spend years building wealth through their business ventures but then fail to diversify the fruits of their lifetime of labor. Simply put, diversification protects us from our own biases, mistakes, and inevitably taking our eye off the ball as we begin to enjoy the fruits of our labors. Many believe the success they experienced in their careers will translate into investing. And of course it might, provided the wealth is employed in strategies beyond one asset class, or even a single managed futures strategy.
- We estimate the probability of something by how easy it is to bring examples to mind. Schneier: "Newspapers repeat rare risks again and again. When something is in the news, it is, by definition, something that almost never happens. Things that are so common they stop becoming newsworthy -- like car accidents -- are what you need to worry about." In investing: Most recent polls show investors' biggest fears center around inflation and national debt. These are legitimate risks, but they pale in comparison to a common risk that utterly derails so many people's finances: Our investments don’t keep up with inflation and as a result of a lack of diversification, they are at risk to large losses such as experienced by investors in 2008. Yet people continue to fail to diversify, not realizing the benefits of investing in multiple non-correlated asset classes.
An undiversified portfolio is not just an amateur mistake. Many professionals don’t favor diversification because of the bizarre way money is managed in this country. If you concentrate all your investments in one sector and the sector takes off, you will beat pretty much every diversified fund out there. That's the nature of the beast. You then can market yourself as a huge success and get profiled by every magazine and take in capital from unsuspecting folk who don't know how much risk you truly are taking on.
In such cases, both amateur and professional are wrong; controlling risk is the key to long-term rewards and controlling risk means employing diversified investment strategies at all times.
At Novodyn Advisors, our strategy, NDC Mean Reversion FT, is a short-term systematic trading program. Our investment objectives address: a) diversification through trading multiple US-regulated markets; b) Non-correlated returns to the S&P 500; and c) minimal risk through low margin-to-equity ratios.
Through the usage of Fourier Transforms, the strategy is designed to identify short-term price waves to resolve the amplitude of price waves, thereby removing white noise, or random walk. Positions are usually of short duration, averaging holding periods of 1 to 4 days. By executing multiple short duration trades across a variety of strategies and time frames, the program endeavors to avoid kurtosis (“fat tail”) risk, which describes events outside a normal distribution such as market “crashes”.
Our position is that every investor should have a diversified basket of non-correlated investments to provide the best risk-adjusted return if the stock market crashes. Our NDC Mean Reversion FT Managed Futures program could be just one piece of the investor’s financial puzzle due to our non-correlated performance when compared to traditional equity investments.
For information about NovoDyn Advisors’ programs contact:
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