Last Updated on June 19, 2022 by Quantified Trading
Mark Spitznagel, Safe Haven – Investing For Financial Storms: What role can risk-mitigating and defensive assets play in a portfolio? Do we use them only to seek shelter until the passing of financial storms? Contrary to what we learn at schools and universities, can higher returns actually come as a result of lowering risk?
In his recent book called Safe Haven – Investing For Financial Storms, hedge fund manager Mark Spitznagel tries to answer these questions. He explains what a risk-mitigating asset is and sets out the theoretical framework for how such an asset can both reduce risk and increase returns.
Mark Spitznagel has a low profile in both traditional and social media and was up until the Covid-19 mess in March 2020 most known for being a friend of Nassim Nicholas Taleb (?). But a sudden windfall of gains in his hedge fund Universa Tail Fund of 3600% made him headlines all over the internet.
Mark Spitznagel’s Safe Haven Investing
According to financial theory, you can only increase returns by accepting higher risk. But Spitznagel argues the theory is plain wrong and goes on to set the theoretical framework on how risk mitigation can raise wealth by lowering risk.
Spitznagel’s ideas are counterintuitive and he sets off explaining how and why a defensive asset has a role in investment portfolios. How can risk-mitigating assets add value?
Spitznagel uses dice games to explain that even an asset that has negative arithmetic returns, in theory, can increase the geometric returns. Compounding and avoiding big setbacks is key (risk mitigation). You can read more about this in this article:
Many investors, especially young ones, underestimate the value of having assets that correlate little with stocks. (Correlation in trading and investing is poorly understood.) Even though the arithmetic average in the risk-mitigating asset is lower than S&P 500’s, it can still increase the annual returns (geometric average) compared to just owning S&P 500. However, the tricks of the defensive assets mainly show up during a recession, which we have not had for over 12 years.
An example of risk mitigation is insurance. When you insure your house, you need to pay a premium to the insurance company. Thus, insurance is a liability – a trade-off against wealth creation. Spitznagel argues it doesn’t need to be like this. Even a negative returning asset can increase portfolio value if done correctly.
Spitznagel mentioned examples of risk-mitigating strategies could be:
- 80% invested in the S&P 500 and 20% in gold
- 50% in the S&P 500 and 50% in Trend-following CTAs
- 66% in the S&P 500 and 34 in long-Term Treasuries
- 85% in the S&P 500 and 15% in Swiss Franc
You need to have risk-mitigating assets to offset the sequence risk. Even though the market has risen about 10% on average, you can end up with a lot less (and more) if the sequence of returns is different. We showed this in an example about dollar-cost averaging vs. lump sum investing.
Spitznagel shows how the above assets can reduce risk, but do a poor job of increasing returns. Unfortunately, he stops there, which is somewhat disappointing. As an alternative, we wrote our own take on tail risk hedging strategies.
My own take on Mark Spiznagel’s Safe Haven:
I waited many months for this book but must admit that it was a bit disappointing. It’s a great theoretical read but offers close to zero in terms of efficient practical examples. Spitznagel offers not even the slightest hint about his trading strategies.
Early on, Spitznagel writes that he will not give any insights on how to create a safe haven portfolio – you need to find out yourself. Is the book a sales pitch for his hedge fund Universa? I don’t know. Spitznagel keeps his promise in the remaining chapters of the book (of not providing an example of an efficient risk mitigating asset) and my takeaway is pretty modest.
After reading the book, I’m still at a small loss on how I can construct an efficient risk-mitigating portfolio. After Spitznagel backtests risk-mitigating assets of cash, CTAs, bonds, and gold (and concludes they are not lifting the efficient frontier) the book abruptly ends. None of his methods are actually disclosed, not even a hint.
To rephrase: if you like to fish, you would want a book that tells you how to fish – not the theory behind it. I understand that his ideas might be proprietary, but not even a hint is mentioned throughout the book.
I find the theories of Taleb and Spitznagel intriguing, but how can you use them efficiently in real life?
I have yet to see any audited results of the funds Empirica and Universa (both Taleb and Spitznagel are involved), even though Spitznagel writes on page 187 that Universa has audited 100% returns on capital over the last decade. How much capital do they manage? I don’t know. To my knowledge, Empirica has never disclosed any proven track record.
Takeaways and quotes from Mark Spitznagel’s Safe Haven:
I like to take notes while I’m reading. Below are the most interesting quotes from the book:
From the foreword of Nassim Nicholas Taleb:
Never underestimate people’s need to look good in the eyes of others.
People’s only excuse for using these models is that other people are using these models.
The Nobel-decorated academics proved in a single month, the fakeness of their model (about the book When Genious Failed)
…it is OPM (other people’s money) they are risking while the returns are theirs – again, absence of skin in the game
Steady returns come along with hiding tail risks.
From the book:
Talk is cheap. Ideas and commentary are just that. Significance only comes from the doing, from action within the arena.
A small loss is a good loss
If you take too much risk, it will likely cost you wealth over time. And at the same time, if you don’t take enough risk, it will also likely cost you wealth over time.
After all, according to Popper, science is the art of systematic over-simplification.
A quote from Ian Fleming’s Moonraker (James Bond 007):
Before he slept he reflected, as he had often reflected in other moments of triumph at the card table, that the gain to the winner is, in some odd way, always less than the loss to the loser.
This is the rule that it is advisable to divide goods which are exposed to some danger into several portions rather than to risk them all together.
Only ideas won by walking have any value.
Markets scare us far more than they harm us.
Risk somehow always appears so obvious and predictable, and the last crash always made so much sense, retrospectively, that is – based on what we now know, but what wasn’t known at the time.
In investing, good defense leads to good offense.
…because the math of the whole – or of arithmetic averaging – is so intuitive, while the math of the whole – or of compounding – is so counterintuitive.
The “hedge” in hedge fund has become very much a misnomer.
The net portfolio effect – or the cost-effectiveness of a safe haven – is thus driven by how little of that safe haven is needed for a given level of risk mitigation.
Being very safe and very unsafe can both be very costly.
You get what you get, not what you expect.
The compounding effect is the most destructive force in the universe.