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Kris Abdelmessih on Having an Edge

This week we are doing something a bit different; and instead of hearing from me, we’ve asked one of our users to share their perspective on investing and Composer. 

Kris has been trading options for 21 years. His experience includes getting his start in the trading pits with SIG, founding his own market-making group, and running the commodities book for a prominent volatility manager. Now, among other projects, Kris writes a weekly newsletter, Moontower, that helps readers think about risk and decisions in markets and life. 

So, a huge thank you to Kris for sharing his wisdom and for giving me a break this week. 

As this is a testimonial there are a few disclosures. Here we go: The below is the opinion of the authors. Any conclusions are their own. This should not be considered as investment advice. Investing involves the risk of loss and returns are not guaranteed. This writing is an uncompensated testimonial from a current Beta user of Composer.

Now with that covered.

Take it away Kris…

Investing is not a one-shot deal. It’s not a lotto ticket. It’s a repeated game. It mirrors life itself. So the most important rule is survive. If you can avoid the zero’s in life and investing you are ahead of the game. Addition by subtraction. 

This is easy to demonstrate by seeing what the opposite looks like.  

In Superman III, Richard Pryor’s character devises a get-rich-quick scheme to collect all the half-cents that get rounded away in his employer’s accounting system. If Pryor hadn’t raised suspicion by driving a Ferrari to work, he might have gotten away with it. Instead, jail. 

Poor risk management.

In the real world, many businesses look like a “skimming a cent” scheme except they are, well legal for starters, but more importantly, they are valid commercial behaviors. Sometimes it’s explicit. Visa takes a cut of millions of credit card transactions. 

Sometimes it’s more opaque.

Investing is also about collecting small edges. But that’s only half the battle. Hanging on to those profits is not only the other half, but surprisingly, what you need to focus on first.

I’ll show you why, but first let’s dive into exactly how investing is about having an edge.

Having An Edge

Investing reminds me of the casino business. Not like gambling (unless Robinhood is your definition of investing). Investing is like running the casino

Casinos get paid in “mathematical expectation”. [1] You don’t have to pay to play roulette, but the house edge is about 5% of every dollar bet. You might win on any one trip to Vegas but in the long run the odds are against you.

Let’s zoom in on the casino’s point of view. The casino wants to force the “long-run” to come sooner. It does that by having many games and many customers. The games provide diversification as they all have different payout distributions. The variation in games appeals to a wide range of the population. The casino can compute a predictable stream of revenue with a fairly tight confidence interval.

The casino’s “portfolio” is significantly less risky than any of the games it offers even with its house edge. This allows the casino to have a much lower cost of capital than say a skillful poker player who gets staked by investors. The individual poker star is still an underdog to win any large tournament even if they have positive expectancy for entering it. Their cost of capital is high because they are undiversified. [2]

Diversification is the casino’s first layer of defense. But it’s not sufficient. Think for a moment.

What risk control (besides security cameras) stands out when you are a casino?

The answer:

Betting and payout limits. All the diversification in the world won’t make a difference if you let Elon Musk bet $1B on a spin of a wheel.

A Portable Lesson

I joined a large option market-making firm straight from college in, coincidentally, Y2K. The business model echoed a casino.

  • Collect a small amount of edge, in the form of bid-ask spreads around an option contract’s “fair value”

  • Manage the risk of inventory you are saddled with in the course of business

While derivatives and securities are much harder to price than casino games the concept is the same. If you are pricing correctly and able to acquire market share, your long-run profits will reflect the margin you make on all your trades.

The key is survival. And the key to survival is risk-management.

Core Tools of Risk Management

Just like the casino, the most critical aspects of risk management, and by extension, survival are:

  • Diversification

  • Sizing

Conceptually, the casino business model is an adaptive way to think about investing. But as with any analogy, the details and implementation differ. Let’s look at diversification more closely to see why.

Diversification

As a professional trader, you accumulate a pile of positions with many properties that cancel each other out. Risk management requires measuring and then hedging the residual. The “canceling out” or netting of positions is laden with assumptions. That’s what option “Greeks” are for.

For example:

  • Weighted vega is a single number that condenses volatility exposures across a term structure

  • Net beta is a similar measure that collapses the portfolio’s directional exposure to a single number

A professional trader will immediately recognize the load-bearing assumption underpinning these summaries: correlations. It’s fairly self-evident that if you hold 10 or even 100 stocks but they are perfectly correlated, you are not diversified.

The casino doesn’t face this problem. The high-fiving at the craps table has nothing to do with what’s happening in blackjack.

Since diversification is critical for survival, investors rely on correlations not all just jumping to 1 (i.e., assets becoming perfectly correlated). But since correlations change, this is a regrettable possibility. That’s why sizing is so important. It’s the last line of defense.

Sizing

You ultimately need to constrain how large your allocations get. If you rely strictly on low correlations when combining positions, you could be fooling yourself into thinking you are diversified.

Imagine you own 2 stocks with zero correlation and put half your money into each one. If correlation jumps to 100% it’s as if you put all our eggs in a single basket. You can use sizing rules that do not have a correlation input as an additional security measure.

Popular examples of this:

  • risk parity strategies (these rely on volatility inputs, specifically the ratio of volatilities which is a more stable measure than correlation) see

    Balancing Risk

  • equal-weighted strategy. Just spreading your money equally across your portfolio

Techniques To Express Our Risk Management Principles

With the understanding that risk management is the key to your portfolio surviving to see its goals, you must be laser-focused on diversification and sizing. I can’t overstate the importance of what you just learned. You have, with little effort, internalized the most foundational insight from traders and market-makers. This class of participants, collectively, has the largest sample size of dealing with edge and risk and yet their lessons hide in plain sight. Instead, most investing discourse is focused on returns and predictions. This is “tourist” thinking. It’s guessing and dreaming. And guess what it’s for? To sell you on coming to the flashy new casino.

Let’s save our money and copy the pros. Let’s focus on how to manage risk. Specifically, how do we maintain diversification and prune sizing?

Rebalancing

Rebalancing just means restoring the weights of your portfolio back to their target allocations. If an investor bought AMZN 20 years ago, their entire portfolio would basically be AMZN today. I can see your face...”umm why would I want to re-balance again??”

One word: Enron. The stories of employees seeing their nest eggs dissolve in a matter of weeks were harrowing lessons about the risk of an over concentrated portfolio. Rebalancing is the remedy. The price is FOMO (imagine Enron doubled instead of collapsing). The value is survival. If you don’t survive, you don’t get to play anymore. Rule #1 is always survive. Never risk what you need for what you don’t.

Practically speaking, many ETFs reference indices or portfolios that have some built-in rebalancing (although often as seldom as once per year). You may prefer more. In addition, single-idea ETFs like commodity funds USO or GLD can be used as diversifiers. They require an investor to trim or add as they bounce around relative to the broader portfolio.

Momentum Rules

Momentum rules are a pre-registered plan to stick with a trend or cut losses. For example, if an asset is up 10% in 3 months buy it, if it falls 3% in one month sell it. The specific parameters are customizable, but momentum rules are risk management rules.

The cost of a momentum rule is missing the early part of a trend. You will never buy a bottom. But the value received in exchange for that cost is not hanging on to losers.

The beauty of such a tool is that it complements rebalancing techniques that automatically trim winners and dollar-cost average losers.

By layering rebalancing and momentum guardrails into your portfolio, you are maximizing your chance to harvest market returns throughout your investing life.

Marrying Risk Management With Returns

Returns are compensation for risk. If stocks were not risky, they’d yield the risk-free rate. You are being offered a return because stocks and their underlying businesses are uncertain. The casino table is flipped around. You get to collect the edge as an investor.

Just as casinos and market-makers stack edges, you harvest various risk premiums embedded in different asset classes. Risk management (primarily diversification and sizing) ensures your portfolio survives to realize those risk premiums.

This is where Composer comes in.

Why Composer Is Such A Big Deal

Once you are focused on asset allocation your thinking moves from the company or security level to the portfolio construction level. This makes sense since sizing will have a larger impact on performance than security selection.

I think of Composer as the sweet spot on the automation-customization spectrum. Robos are a compromise that tilts heavily towards automation while trading individual stocks is pure customization. For those of us who don’t want to spend our time throwing darts, we can take advantage of ETFs’ tax structure and versatility yet concentrate our efforts on risk management.

Your goals and risk tolerances are deeply personal matters. Composer allows you to automate rebalancing and loss-cutting rules. You can think of a robo as simple cruise control where you set your speed and heading only. Composer is autonomous driving, where the machine uses the rules you created to intervene when we are no longer on a straightaway.

Conclusion

I agree with the notion that discipline is the key to investing. You’ve heard the cliche, “Time in market not timing the market”. Since it’s just one line, the cliche is unable to tell you how to do that. How do you stay invested so you can keep growing? Risk management. It is the foundation of discipline and therefore the root of survival.

Composer is a modern tool that I believe may lower the cost of risk management. No coding, no external spreadsheets, and no maintenance to keep up. You can take an active role in designing your own risk management strategies, borrow snippets from other Symphonies, or simply subscribe to Symphonies that align with your own goals and tolerances.

It’s the tool I’ve been waiting to see someone build. I’m delighted to find a team that shares my views about what the largest muscle movements in investing are.

Kris Abdelmessih

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