During his recent interview with Tobias, Mikhail Samonov, Founder and CEO of Two Centuries Investments discussed why Studying Historical Markets Makes You A More Resilient Investor. Here’s an excerpt from the interview:
Tobias: There’s a few philosophical questions. Why use a very long time period to– What does that give you?
Mikhail: First thing, it gives me a better sense of the truer distribution of whatever we’re looking at. We all know things are not normal in finance, even the basic S&P 500 returns are not perfectly normal. If you look at left tail, which is what we’re worried about, the crashes, we know they’re not normal. So, if we just look at short history, we’ll totally miss them, most likely. Especially if we accept the strategy and start investing using a strategy, it’s very likely that a left tail was not in the recent past, unless you’re very unpopular and you’re just going to go at it.
Starting with Momentum, when I discovered the first left tail in 1933 and Fama-French data, I just got obsessed. What other left tails can we find? And [unintelligible [00:35:25] 200 years of history or 125 years of history, we’ll give that a shot. The second is this thing that keeps– When I was at college, I was a more theoretical econ guy, definitely didn’t believe it was possible to beat the market.
That was actually– I was very influenced by markets are efficient and forget about it. And then, when I got that first job as a quant, where I had to come up with a model to beat the market, I was terrified. Almost out of fear there, I’ve just kept like innovating. So, this idea of data mining where these factors are data mined and they are real, when you add untouched– it’s not pristine in terms of quality but it’s pristine in terms of nobody messed around with those 130 years of data. And you test something and it comes back with a positive statistical t-stat, it’s like, “This thing is real. I can almost touch it.” At least it might be dead now but at least it existed and I’m not just miraged by somebody fitting in history. And so those are the two major, major reasons.
If I continue to studying when something happens like a crash and trying to explain how there are factors in the macroeconomy or innovation or Industrial Revolutions, or whatever it is, that help understand the spreads. But I think it’s very hard to time them just in production point of view, even to implement these trades on timing factors. It’s very hard to give up a lot of correlation benefits because they don’t correlate.
So, if you start overweighting one, you’re just sacrificing a lot of diversification and that’s not even to mention the fact that predicting when one does better than the other. It’s really, really hard. So, I like history from– it gives me confidence about the left tail. And the thing with left tail– my whole philosophy just for a second about what is risk? What is volatility? It comes in here and that’s what drives Two Centuries Investments, the firm I started.
I think about it as an asset owner, less as an asset manager, making products, raising assets, that’s all great. As an asset owner, my own capital is long strategies, what is risk for me? Volatility is different. Volatility is something is moving up and down. If I understand it, if it’s expected, if it’s normal, I don’t sweat things. Risk is when I give up on something. Risk is when I have to change a strategy, I’m going to lock in permanently some losses. I’m going to give up the unrealized gains and cancel out long-run compounding, start over. Risk is when you’re lost, you don’t know what to do, you give up.
It’s kind of behavioral for me, but looking at left tails, those crashes for value momentum or in my case, asset allocation like 60/40 or other stuff, I want to really put in that worst-case as if it is really a worst-case. Like 60/40 portfolio, worst case has been almost 70%. Doesn’t mean the future can’t be worse. Hopefully is better, but can be even worse than 70%.
But if I can’t even stomach 70% loss, and statically keep rebalancing– when that’s happening, that means you have to be selling bonds and buying stocks more and more during that depression. If I can’t honestly stomach it, and I have a long-term investment horizon, and I want my capital to move through decades or centuries for my kids to keep doing this, I’ve got to put in these long-term expectations that history gives me has actually that it could happen tomorrow, or it could happen 200 years from now, I don’t know. Building around that makes you more resilient and there’s less risk in the system, that risk in terms of giving up.
And then, you set up these expectations based on those bad case scenarios. If real life, you’re still within those expectations and you can sleep at night, it’s just volatility, that’s the kind of experience I want to have versus setting up very great high expectations, low risk, low volatility, low drawdowns, and then being constantly surprised. This stopped working, that stop working, what did I do? It turns on this like survival brain, which is you’re either regretting stuff or is worried. Fear, agreed. The words I like is anxiety and regret. It’s all this primal brain. When it turns on, it just doesn’t let you go. You’re going to be feeling it. You have to do something. We see people doing that all the time across levels of experience, committees, all the way to retail.
This year really amplifies both the value and asset allocation are static, this problem. And so, the more I can be in my frontal lobe, the executive brain, and all this stuff helps me stay there. Being rules based, systematic, study long-term history, be comfortable being unpopular.
Not being too afraid of having original ideas, because at the worst case, they’re going to be random noise. Versus popular ideas, at the worst case, get crowded and then you get this big capital movement. So, there’s that correlation with other managers. So, you could actually swing from a positive t-stat to a negative t-stat. It’s a long way of answering, why do I study long-term history. I don’t obsess about it too much. It’s just one of the tools I have, but it fits nicely within the risk management approach.
Tobias: Yeah, I love that. I couldn’t agree more. Just looking back over the 200-year history that you’ve created for value, what are the takeaways for you? What surprised you, what can we learn from that 200-year period? For example, one I would have thought was that at 59% drawdown in a long-short was entirely possible. And here we are, we’re about to confront it again. So, it’s not a theoretical possibility. It’s very real and we’re living through it right now.
Mikhail: Exactly. It’s very similar to Momentum. So, what’s shocking is how similar it is to my Momentum experience. When I looked at those results in ’08 and then ’09, and boom, there’s this massive crash that you never thought you’d see but you were afraid you will. Same things happening with value right now. You take all that long-run history and you think that’s really relevant. We’re living through something very similar. It was so tempting to say it’s totally irrelevant.
The second thing that was surprising is how safe this second half of 20th century for value was, and you have these great value investors that are like literally riding a wave. Of course, they outperform traditional value and add a ton of value on top of that, and there’s many other reasons they succeeded. One of the important ones being the psychological where I believe when you really go deep into something, you’re going to hold on much more in terms of risk of giving up. I didn’t give up in the 90s, kept going, got paid.
But zooming out, there was definitely a lot of positive wind pushing them in this value. And now, you see the cracks. Not even cracks, but the pain, the real deal. When you have a 60% drawdown in value, you start thinking about permanent loss of capital and because things are getting priced into that are looking really, really scary. So, I think that’s a real test for a lot of the value folks out there and I sympathize with that.
Tobias: Yeah, I love the way you frame it up. You said 1940 to 2006 was exceptionally safe, and I love that. You mean that in its literal sense. And then, the takeaway probably should be that value investing is not safe, that you can expect these gigantic drawdowns every now and again.
Mikhail: If you’re thinking about volatility, absolutely not safe. That’s where the risk premia argument often I think is just wrong. When people say, “Well, it’s volatile, it crashes, hence it must be risk premium.” That’s a very slippery slope theoretically, academically. But on the other hand, if your process is value investing, you just feel great owning undervalued companies, you have a process to do it, and then you look at 200 years and say, “Yep, one decade out of a century, it’s a 59% crash. I’m okay with it, we’ll just get through it.”
As an asset owner, you can do it. If you really believe it and you and you feel great, who cares? It’s still total return. I mean if you doing long-short, it’s really painful, but you can still hold on to that crash. If you’re doing long-long, you still have this just general market data pulling you up, and you’re lagging S&P for a while. Who cares? As an asset manager, it becomes a different story. It’s career risk, it’s clients get impatient, and all that.
One big thought, I’m working, recently expressing to people finally just to share is just like people either love or hate long-term history, people tend to split love or hate, active versus passive. They just fall into these two camps. They love alpha or they hate alpha. Or they love beta or they hate beta. As an asset owner, that’s an asset management headache. As an asset owner, yes, those are useful risk management concepts. But really, I care about total return with survivable cross risk. Survival meaning no margin calls, and I don’t give up on the strategy, that’s the main– [crosstalk]
And the total return can come– When it’s coming, both from alpha and beta, that’s even better. There’s two sources. If for a decade, it’s all beta and for another decade, it’s all alpha, it looks like a horrible passive management product. But as a total return concept, it’s great. Why not? Because you’re sticking with something, versus just having a passive index and then you still give up. Somebody comes in– like with Jeremy Siegel, he was in the stocks for a long run. His book, I loved it. And then he moves everything to dividend investing. And then to 60/40 and now 75/25, and there’s very strong intellectual reasons. But for me, that’s risk of investing. You start on path A and then you’re on path B and then you’re on path C.
So, to avoid all this, my takeaway from all of this is, yes, studying history, building your personal resilience, and just keep doing what you’re doing. Evolution and innovation is also part of my DNA. But if you blend things well, you continue to innovate, without having to switch what you were doing. There’s another misconception, I think people just obsess with investment process, and it’s just been these safe guardrails for people, which were good. I guess investment management back in the day, you could just switch around and go crazy.
So, all the asset owners put on this tracking and benchmark and don’t switch your style, stick with the process. That’s all great. But that’s all risk management. But where’s innovation in all of this? Where’s your edge? How do you keep moving forward? So, that’s balancing all that. And it’s never black and white one way or another. If you overdo one of those things, you’re going to get hurt.
But as an optimizer, you’re pulling different forces together. A good balance, [unintelligible [00:47:22] when I say they’re balanced, there’s really this battle going on inside of it, like sell, sell, sell, buy, buy, buy, and optimizer just finds that point, utility function, even if there’s some noise there. I like it when there’s tension. So, innovation versus investment process is one of those things that are pulling and pushing. But I think that’s where some of the success can be found.
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