No, this isn’t about Tina Fey or Tino Martinez. Last week’s piece raised a number of questions about what exactly “being cautious” means, so thought I’d do a follow up to try to bring further clarity.
Being cautious doesn’t mean sell everything…or even sell anything. It means be aware of the various risks out there and take them into account when you make decisions. I could probably stop there and call it a day, but I’m guessing some of you will want more.
It also means don’t fall for false narratives like “there is no alternative” (TINA) so you have to buy stocks regardless of risk. That’s nonsense. That’s the type of logic people use before they do something really risky or commit a crime. “I lost my job and can’t feed my family. I didn’t have a choice but to rob the bank.”
There are always other options. Holding cash isn’t a sin. Underperforming in the short term to outperform in the long term isn’t a sin (though I understand in certain situations it can create career risk). Are these things hard to do? Yes, but they are alternatives. The question is how do you know when is it the right time to make a hard choice?
It isn’t an easy thing (since if it were, most others would have already acted and it would be too late), but I can try to help. Perhaps it would be easier if we use some insurance parallels.
The Investing Soft Market
Let’s assume we’re at a point in the market where Florida wind is very underpriced. You could write it anyway and hope nothing happens this year and you get away with it. That’s the equivalent of buying your favorite celebrity’s SPAC. It might work for a little while, but it’s not a good idea.
What most underwriters do in that situation is the underwriting equivalent of TINA…if I can’t write Florida, I’ll go write Texas or Japan. That’s way underpriced too, but it’s less underpriced so it’s the best alternative! This is the equivalent of buying Tesla instead of that SPAC.
You could say it’s not the right time to write cat, so I’ll switch to casualty. Now, I’m a cat underwriter who doesn’t know that much about casualty, but how bad could it be? After all, TINA!!! That’s sort of like the person who realizes stocks are too expensive, so loads up on bitcoin or VIX futures instead. They’d rather lose money on something they don’t know than something they do!
There is another path though. Realize that There Are No Opportunities (TINO!) and reduce your risk. Cut your PMLs back and return capital to your investors until conditions improve. This is the equivalent of selling stocks to raise cash until the market corrects.
How Do I Know If I’m A TINO?
I’m not saying the last option is the right choice or the best choice, but is it a valid choice. And yes, by choosing it, you may do worse than the person who continues to run a full cat book and watches a light wind season go by with no losses. That doesn’t mean the decision making process was wrong. It just means randomness didn’t favor you.
So, like any other risk exercise, this really comes down to handicapping the odds correctly. If you think the current market is like that cat market where everything is priced below technical rates, then it is probably a good time to reduce exposure. Don’t let the FOMO keep you from making the right logical decision.
If you think it is just Florida that is underpriced, but the rest of the market is borderline acceptable, then you can rationalize continuing to participate elsewhere as there is less friction to maintaining a presence in the market than making radical cuts to your book which may not be painless to re-establish once conditions return to normal.
Think of this like one of those online quizzes. Instead of “are you a Monica or are you a Rachel?”, it’s are you a TINA or a TINO. You have to know that about yourself, before you can decide whether to go to cash or if you can still find places to invest without regret.
What Should a TINA Do?
For argument’s sake, let’s assume you decided you’re a TINA (since the TINO choice is fairly easy to know how to execute). What is the investment equivalent of a diversifying zone and how should you manage exposure to it to limit risk if things go wrong?
First, your “diversifying zone” should be less mispriced than your peak zone. Second, it should be a limited, not concentrated, bet. Finally, it should be less volatile than a peak risk.
I’m not going to give specific suggestions, but, for illustrative purposes, what we traditionally called Blue Chip stocks would be a good example relative to stocks in the Ark ETF.
If the market goes down, those will go down too but likely less. If we have a melt up, they will lag the broader market but still outperform cash and likely bonds. They also tend to be highly liquid, so if you see the market start to wobble, you can get out quickly.
And that raises another point. Unlike cat risk, where you’re on it for a year no matter what, most capital markets provide liquidity. This is very valuable. While I’m not advocating market timing (because most people are bad at it), a momentum based timing strategy isn’t the worst idea in the present market.
That would suggest staying long until we have a sell-off and then dump a lot of your exposure. The market doesn’t tend to go straight down. It usually chops it’s way to big selloffs and you get some opportunities to get out before the free fall. If you are worried about missing a melt up, this would be the best way to play it. Just be sure to actually follow through when you get that first 5-10% sell off.
There are certainly a number of “boring” choices to consider. I’m not suggesting it has to be blue chip stocks. It could be high dividend names, value stocks (though that is now performance chasing), international exposure, commodities, etc. You need to figure out what makes the most sense for you, but there are a number of options if you want to keep invested, but reduce your volatility risk.
What Should a TINA Not Do?
Just as important as what to do is what not to do. Don’t buy things you don’t understand just because they go up every day (for now). If you don’t know how to price casualty, don’t write it!
There are people who do understand casualty and they’re going to write the good contracts while the broker brings you all the stuff the smart guys won’t touch. It’s the same thing with SPACs or Bitcoin or a cloud provider IPO. There are people who know what’s going on and, when they realize the party is ending, they need suckers to sell to. Don’t be that sucker!
I mentioned PMLs earlier. This concept also translates. Your capacity for tail risk should be a function of the expected return. When future returns are low, it’s foolish to continue to deploy your full PML. Well, when future expected investment returns are low (which be definition they are, over at least the medium term, given the strong performance of recent years), it’s foolish to own as many high risk assets as you did a year ago.
So take some gains and redeploy into some of those lower risk assets. And if you are using margin or other forms of leverage, this is the time to start closing that down before you get burned.
Insurance CIOs Should Be TINOs
By the way, all of this applies to insurance companies as well regarding credit. If something happens to spook the broader market, there is a good chance credit gets shot too. Credit spreads are at historic lows. CIOs should be taking gains while they can.
If we get an inflationary scare, not only will credit spreads go up, so will real rates. That means big hits to bond prices. Move up in credit quality now and sacrifice the yield. I know that is hard to hear, but if rates gap up, you can get the income back later by reinvesting at the higher rates.
A Final Thought
So is it TINA or TINO? Let me frame it one more way. The downside to following the TINA approach is if things go south, not only do you lose money, you likely don’t have the excess capacity to buy cheaper assets.
To keep beating the cat market analogy to death, you’re unable to participate in the coming hard market. Another way to say this is there is an opportunity cost to TINA. You may miss out on buying cheap assets in the future.
If you believe in TINO and accept that opportunities are slim today, your opportunity cost is the potential near term melt up. However, you create the opportunity to benefit from any near term selloff.
So the algebra is really as follows, do you think you can make more betting on a near term melt up but with higher than normal risk of a crash OR can you make more sitting out the latter innings of a bull market and accumulating capital to take advantage of higher returns at some unknown point in the future?
There isn’t a right answer (and there are choices in the middle as shown above) but the point is people should be thinking about these choices rather than blindly riding the bull.