I was watching a video of Jim Grant of Grant’s Interest Rate Observer commenting on the global macro outlook. He mentioned an anecdote involving Cleopatra’s bracelet. Basically it goes that, if Cleopatra’s handmaiden had taken one of her bracelets at the time of her death, sold it for the equivalent of $100 and invested it in a perpetual bond at 2%, she would have enough money to give every person alive today $33 MILLION.
But not one person in the world has even done anything remotely like this. Moral? On a long cycle we cannot even expect to grow wealth, we lose wealth.
Why is that?
Our take is that uncertainty or “what we don’t know we DON’T know”, comes and hits us on the back of the head and in the pocket relieving us of some or all of our hard earned wealth.
If we did expect it, like a known risk with a known probability, we probably would have hedged against it. Like home and contents insurance. Or medical insurance.
But you have to believe at least one of the six impossible financial things before breakfast in order to believe you can, and more importantly SHOULD, hedge against uncertainty or against something that you cannot even ascertain yet.
Furthermore we studiously ignore the effect of volatility “drag” on our wealth. The higher the volatility the quicker it erodes our wealth e.g. a portfolio that goes up 20% and then down 20% a year for 30 years will end up with approximately half of the original portfolio.
Wealth, being a non-swimmer, must wade across the river of life. We ask only one question of the river Gods, the wrong question: “What is the average depth of the river?”
The REAL question should have been “What is the most extreme depth my wealth will most likely encounter during its “wading” and how high can the waves get peak to trough?” I.e. how much tail risk and volatility can we expect?
If the answer is “higher than your wealth is tall”, then you better make a plan or else you will be eating pet food in your old age…
And so throughout the ages wealth is constantly eroded away….
Fortunately for us there is a huge derivative market where hedging is available. The hedge for volatility and uncertainty is predominantly options and the “global financial actuary in the sky” who sets the price of the hedge, seems to have dementia as he has already forgotten about 2008. We have the chance now to buy hedges at pre-2008 levels, i.e. cheap.
But believing that he has dementia is the sixth impossible financial thing to believe before breakfast….
The others according to our fantasizing are as follows:
- Interest rates determine the price of supply and demand of credit.
- Governments must work off a budget.
- Banks limit their leverage.
- Central banks don’t have two competing goals of unemployment and inflation.
- There is a financial wonderland where bad assets go to die.