Sibling Rivalry
As my kids would say, I have a low-key dislike of articles that start with some tangential story that sets the context for what follows. I like it even less if the headline is designed simply to grab the reader’s attention without any intention of delivering on what it promised.
So, why pick these two Old Testament examples of bitter sibling rivalry? I promise the headline will deliver, but let me digress for a bit to explain to those whose Old Testament knowledge needs a brief refresh.
Cain and Abel
Cain and Abel were sons of Adam and Eve. Cain was the firstborn. Sacrifices were a great thing in OT times. The brothers decided to make offerings to God, no doubt seeking some kind of preference.
Cain, a farmer, brought God produce from his fields. Abel, a shepherd, brought God the fattest of his herd. God liked Abel’s gift better. Cain killed Abel out of jealousy, and God banished him to the land of Nod. He and his family perished in the great flood.
Jacob and Esau
The next pair—twins this time—were in a different kind of rivalry: for their blind father, Isaac’s blessing, or birthright. This conveyed status and also a double portion of the inheritance. Esau was the more impulsive brother: at one point, he traded his birthright for a bowl of soup and took wives not to the liking of his parents.
His father was still ready to forgive Esau, but his mother, playing favorites, was having none of it. She counseled Jacob to deceive his blind father by dressing up to pretend to be his brother. It worked, but Jacob had to leave to avoid his brother’s wrath and stay with his uncle Laban, where he, in turn, was deceived (into having four wives, overlapping, so…).
Back to Risk and Return
That’s the refresh. Why bother? Well, just like risk and return, you can’t really have one without the other. No Cain without Abel. No Jacob without Esau.
Again, why the set-up? The sibling relationship in both cases was a complex one. It contained layers of complexity. Why did Cain and Abel bring a sacrifice? How was the respective worth of each calibrated? By what benchmarks? What was the return each sought? Why was the jealousy so extreme as to warrant the murder of a sibling? What else was going on?
With Jacob and Esau, how had the relationship between mother and son evolved to the point where Jacob received such preference? How was the plan formed, and how did it work out for Jacob in the end?
Risk Tolerance
The relationship between risk and return is similarly complex. The basic construct is that, in order to increase return, there must be an increase in risk. It seems fair, right?
I trade the risk of suffering a greater loss for the prospect of a greater return. If I want less risk, I buy Treasury securities, which will yield a lower return than buying, say, Nvidia.
If you want to sleep well, take less risk. Maybe. But, maybe you lose sleep over the lost opportunity, the FOMO of your peers who brag about their wins in tech investing, while you book 5% for 3-month T-bills.
Maybe, objectively, Cain knew his bushels of wheat weren’t as much of a sacrifice as Abel made with his prize calf. Maybe Jacob had invested more in his relationship with his mother than Esau. Maybe he was more skilled at using his skills to get his returns.
The paradigm of risk and return contains some kind of moral lesson. It is something that every retail investment advisor has to quiz their client about before managing their money. What is your risk tolerance? That’s a complicated discussion.
How much do you have to invest?
What is your time horizon for achieving your investment goals?
What represents 6 months of liquidity to meet your expenses if you lose your job?
How much loss can you stand to see in your account in pursuit of your investment goals?
Here’s a great example: if you had invested $1,000 in Bitcoin on January 1st, 2011, you would be worth $235MM today!
Entry Point
The chart, of course, can tell many stories, depending on where your entry point was. An investment at a market peak in 2014 would have seen your investment lose nearly all its value. And yet, if you had hung on for 10 years, you would have still earned 50%.
If you had invested a significant portion of your net worth and seen it go close to zero, the ride would have been bumpy. Your perception of risk taken vs. return achieved may have differed substantially from an investor who put 10% of their portfolio at risk in Bitcoin.
Your risk tolerance at 10% of your portfolio would have been different, and your return would probably have been much higher because you would not have been compelled to cut your losses at some point on the way down to a 98% loss.
As an institutional investor, you would never have made the investment in the first place. Your performance is benchmarked against some blend of the S&P 500 and a bond index. If you fail to track the benchmark for long enough, you will be out of a job.
Benchmark Investing
Benchmarks are the north star of the investment universe. They’re how you keep score. How did you do vs. the S&P 500, vs. some blend of that and something more conservative?
How do you decide which benchmark to choose? You may need a certain return each year. A pension fund may need to generate a certain amount each year to pay its participants’ pensions.
Those payments may represent 6% of its total assets under management. So, its benchmark will likely be at least that, plus some margin of safety.
You may be a hedge fund competing for capital with other hedge funds promising and delivering 12% per annum. Your investors can ask for their money back each month or quarter. They will withdraw their money if you don’t deliver at least 12%. So, 12%, plus some margin for safety, is your benchmark.
Benchmarks Can Mean Different Things
While benchmarks confer some kind of strategic discipline, they can be tricky. Take a look at these two charts:
This one shows a classic risk vs. return chart. The x-axis shows the risk, and the y-axis shows the return. The chart assumes a non-zero return at zero risk because of the concept of risk-free returns. You are supposed to get those by investing in Treasury securities.
The upward-sloping line shows that return increases as risk increases. The benchmark is constructed from various investment options to tailor risk to meet the investor’s comfort level or target benchmark.
In this diagram, the portfolio has achieved something called alpha. Alpha is the amount of return above a certain benchmark at a given level of risk.
Suppose the benchmark is the S&P 500, and suppose that the level of risk in the portfolio is no greater than that of the S&P 500. The value added is alpha.
How is that possible? The value is added, allegedly, by the investment manager.
Look at this chart:
Value added, in this case, is measured by achieving the benchmark return with less risk. Which do you prefer? Great question.
How Do You Know the Risk?
Risk is something you experience only if you lose the bet. The only thing that you receive, as an investor, is a return on your investment or a loss of some amount.
If your investment manager is benchmarking against the S&P 500 and you receive a return better than that benchmark at the end of the year, you are happy. You assume that the manager was not taking a risk greater than that posed by the S&P 500, but you don’t know.
The manager may have taken more risks than they were supposed to. Because the return was satisfactory, you won’t ask too many questions.
Conversely, the manager may deliver the benchmark and tell you they took less risk, but you won’t know that either.
In both cases, the annual performance review will tell a story. If you are an institutional investor, that story will contain charts and Greek symbols designed to illustrate the manager's value added.
Incentives
In the first chart, the story told will show you why you are happy to give the manager a portion of the value added in the form of a performance fee.
In the second chart, although arguably, you, as an investor, benefited from a lower level of risk to achieve the benchmark return, there is no value added above the benchmark out of which to pay the manager a performance fee.
If the risk vs. return theory is correct, it should never be possible to make a return that is not commensurate with risk. In the first chart, the investor ought to argue that the manager took more risk than agreed…
Back to the Brothers’ Stories
I told you I would deliver. Here goes.
Abel is really like the second fund manager, who delivers the benchmark return with less risk. His best offering received less than a fair reward…
Jacob is like the first manager. He skillfully manipulated his position to receive a benefit he may not have deserved.
If only they had filled in their questionnaires at the outset…