"I wanted to win. No, that’s not right. I simply didn’t want to lose."
- Phil Knight, Nike Founder, Shoe Dog
We have a great client that sent me Phil Knight’s Shoe Dog for Christmas. I wasn’t expecting to find a quote so early in my read but on page 3 there it was: “I wanted to win. No, that’s not right. I simply didn’t want to lose.” I couldn’t help but begin a short note to outline the importance of Knight’s statement on a couple levels. Coincidentally, it also lines up quite well with Nobel prize winner Myron Scholes’s thesis on risk management and portfolio drawdown.
No one wants to lose. The effects of losing are paralyzing and alienating. However, winning at all costs can also be paralyzing and alienating. Nobody wants to be paralyzed and/ or alienated. We want to be “…a piece of the continent, a part of the main” as John Donne famously wrote. We want purpose, community, and acceptance. We want to reach our full potential. I think that is pretty universal, so let’s make it practical and relevant in a financial sense.
Portfolios of financial assets do not operate independently; they operate dependently. Portfolio performance is not only dependent upon the assets held but also the investing environment during which those assets are held. Holding the right assets in the right environment allows portfolios to achieve significant risk-adjusted returns. It produces a smoother curve or a higher quality return stream over time. Why? Assets correlate and decouple depending on the environment. As environments change, portfolios should adapt. The purpose? Simply put: not to lose. Said differently, to limit the amount of downside participation relative to upside participation.
Myron puts it thus, “Effective risk management is most important in enhancing terminal wealth (compound returns). Average returns and average historical risks or measuring performance success relative to a benchmark are the current focus. Since the distribution of risks change, risk management to enhance compound returns, however, entails mitigating large drawdown tail losses and participating in upside tail gains. And this is so each period of time regardless of the investment horizon.” The goal is to limit portfolio downside/ drawdown during times of uncertainty and gain upside participation during times of stability. The key is to assess risk objectively as a dynamic cost rather than a static means to a desired end.
Now, let’s talk about the benefits of this approach. First, it imparts confidence during good times and bad (i.e. times of stability/ certainty and times of instability/ uncertainty). There are synergistic ancillary effects of confidence- it promotes more rational decision making and/ or behavior. Times of market irrationality/ inefficiency crop up from time to time, particularly as normal shifts along its spectrum of "normalcy." Being appropriately positioned during these episodes, can present investors with tremendous opportunities rather than calamities. An investor can take advantage of the market rather than be taken advantage of by the market. Next, we are participating in markets rationally in light of rather than regardless of the investing climate. Participation is critical because it promotes the understanding/ acceptance of risk and a probabilistic approach to markets, instead of a binary and predictive practice bordering on market voodoo.