Is Warren Buffett blind to tail risks/risks of ruin?

[JackRab]

You could take the 1250 worst spx days in the last 75 years and that doesn't even come up to 35 vol!

Exactly... those should be stuck at between 16-22 at most. And therefore Warren's trade is a good one!

 

[Surprise]

You guys are missing my point, it's not about me being paranoid about tail risks, its about the following:

Buffett owned "nothing but goverment bonds" all the way to 2008. Then, he took all of that and put into stocks. Clearly there was a 'risk management' of some kind that made him avoid stocks before 2008, perhaps he was being guided by utility (he wanted to ensure he was going to remain wealthy no matter what) or by something else, some sort of tail risk avoidance. Even though he found plenty of cheap stocks before that (and he bought them through Berkshire but NOT with his personal account), and he hates cash long term, YET he STILL avoided stocks with his personal account for YEARS.

But in 2008 that changed, valuations improved and he went "all-in", but as I have argued using Taleb's and the Kelly formula, in most instances more benefits (returns) do NOT warrant one throw caution at the wind like that. He junked his risk management either because:

1)He was being guided by something else, perhaps the deside to maximize Fame/Reputation rather than risk adjusted wealth
2)His is blind to tail risks and simply doesn't believe he can be wrong about the US, no matter what is thrown at the country. So perhaps he thought "ah, I was being paranoid about holding all these bonds, US will come back from this, no need to insure against something that I was insuring before, that was silly"

Either he made a "mistake" before 2008, or he made a "mistake" after it. The way he behaved does not look consistent. Its possible that he wasn't aware that more benefits don't change the decision (or position sizing) much but I doubt, he is quite familiar with the Kelly formula and met personally with many people who swear by it (Thorp etc)

He wasnt all-in .

 

[sle]

You could take the 1250 worst spx days in the last 75 years and that doesn't even come up to 35 vol!

Ha! First of all, the levels he sold in 2007 where nowhere near 35 (a bit more on that in a sec). Second, some of those trades where wildly exotic (e.g. he sold 15y WOP on SPX/SX5E/NKY xUSD in like USD500mm). Thirdly, a big part of "alpha" was his credit rating - he was essentially getting an un-collateralized loan in the form of premium.

PS. 10 year vol is it's own animal due to the interest rate volatility - you have volatility of the spot SPX which is then combined with the volatility of the forward in a non-straight-forward manner.

PPS. all in all, actually pretty good trades on his side and he really f*cked up a few firms with the credit/equity correlation aspect of it, they are still looking to lay off that risk at some ridiculous levels.

 

[JackRab]

Ha! First of all, the levels he sold in 2007 where nowhere near 35 (a bit more on that in a sec). Second, some of those trades where wildly exotic (e.g. he sold 15y WOP on SPX/SX5E/NKY xUSD in like USD500mm). Thirdly, a big part of "alpha" was his credit rating - he was essentially getting an un-collateralized loan in the form of premium.

PS. 10 year vol is it's own animal due to the interest rate volatility - you have volatility of the spot SPX which is then combined with the volatility of the forward in a non-straight-forward manner.

PPS. all in all, actually pretty good trades on his side and he really f*cked up a few firms with the credit/equity correlation aspect of it, they are still looking to lay off that risk at some ridiculous levels.

Ai.. I forgot about the interest rate vol...
But surely dividends are related somewhat with interest rates... rates down, divs down as well? So... Futures move less than based on interest rate only?

What's WOP?

 

[vanzandt]

What's WOP?

Thats the Italian traders.

 

[JackRab]

Thats the Italian traders.

We call those ITAIS..

 

[sle]

But surely dividends are related somewhat with interest rates... rates down, divs down as well? So... Futures move less than based on interest rate only?

Divs are constant short term and blend to proportional long-term. In the US div yields do not seem to correlate much to the rates. Obviously, fuck only knows and when you pricing this sort of shit you do it conservatively.

What's WOP?

Worst Of Put. So at the end, the buyer would have gotten the lowest return of the three indices, crossed into USD. Needless to say that kind of structure is crazy expensive.

 

[Daal]

He wasnt all-in .

"If prices keep looking attractive, my non-Berkshire net worthwill soon be 100 percent in United States equities" - Buffett

"Those individuals or institutions who are long term compounders should consider the possibility of using the Kelly criterion to asymptotically maximize the expected compound growth rate of their wealth. Investors with less tolerance for intermediate term risk may prefer to use a lesser function. Long term compounders ought to avoid using a greater fraction (“overbetting”). Therefore, to the extent that future probabilities are uncertain, long term compounders should further limit their investment fraction enough to prevent a significant risk of overbetting." - Ed Thorp

 

[Martinghoul]

While future probabilities are undoubtedly uncertain, there are all sorts of interesting thought experiments one can perform.

In this particular case, the relevant question is something like this:
"Suppose you are presented with a 99:1 bet. What percentage of your net worth should you bet?"

 

[Surprise]

"If prices keep looking attractive, my non-Berkshire net worthwill soon be 100 percent in United States equities" - Buffett

"Those individuals or institutions who are long term compounders should consider the possibility of using the Kelly criterion to asymptotically maximize the expected compound growth rate of their wealth. Investors with less tolerance for intermediate term risk may prefer to use a lesser function. Long term compounders ought to avoid using a greater fraction (“overbetting”). Therefore, to the extent that future probabilities are uncertain, long term compounders should further limit their investment fraction enough to prevent a significant risk of overbetting." - Ed Thorp

Non berkshire net worth = not all-in .