“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” – Warren Buffett

Stocks and bonds typically have a “negative skew”. What this means is that there is a bigger chance of a large loss than a large gain. This is true even though their expected return is typically positive. In my our, today’s 60/40 US stock and bond portfolio exhibits considerably higher negative skew and lower expected return than the historical average. What this means is that the typical investor is getting little compensation for their risk exposure. This environment makes the search for positive skew worthwhile.

Positive skew is the somewhat rare property of having little downside risk with the possibility of a large gain. Options provide artificial positive skew. An option gives the holder (long position) the right, but not the obligation, to purchase a financial asset at a given price. To compensate the seller (short position) for their negative skew, the buyer pays a premium. Over long time horizons options generally provide sellers with a profit. This means that options are expensive; which is probably why I have not run across any successful investors that recommend holding options over many years. However, nearly every successful investor abides by Warren Buffett’s two rules. These rules imply that we should search for natural positive skew. These are investments that naturally exhibit potentially gains/losses that are similar to that of owning options. In other words, one should search for investments that have limited downside risk and a decent chance of high returns.

Skew is sensitive to time horizon. While stock indexes like the S&P 500 tend to have negative skew over short time periods, the same index has positive skew over very long time periods. This is because shocks tend to be destabolizing. There are many things that can cause economic growth to slow suddenly such as earthquakes, political instability, war, financial crises, and recessions. In contrast, economic growth tends to build gradually. The direction of skew for other financial assets also tends to be intuitive. Oil prices have historically had positive skew, in the short run, as any major disruption in the production of oil in a major oil producing country will send prices to the sky.

Investment strategy should take into account both the expected return on direction of skew. For example, stock and bond investors with positive expected return and negative short term skew would be wise to invest long term. Short term shocks can lead to big losses prompting some to sell at the exact wrong time. In contrast, those invested in assets with negative or zero expected return and positive skew would be wise to invest short term. Portfolios of noncash generating assets like gold, swiss franks, and oil for long periods of time will likely underperform a portfolio of stocks and bonds. All three tend to exhibit positive skew because all three tend to respond positvly to shocks. Swiss franks and gold are viewed by investors as safe havens. When geopolitical events create fear, global investors flee to the relativly small currency driving prices up. Gold also typically has positive skew for the same reason. For the patient investor, these assets can deliver strong returns when events lead to spikes in price. However, in practice this strategy is very challenging because one needs to set a price at which to sell before stability returns and risk premiums return to normal.

Some extremely volatile assets can exhibit positive skew even when there is a real possibility of a total loss of invested capital. Cryptocurrencies and venture capital are two good exmaples. Both are very risky. However, both have delivered returns to some investors amounting to multiple times invested capital despite the very real risk of losing everything. This is one of the reasons we invested in Bitcoin and Ether in early March. As you can see from the chart below, Bitcoin clearly exhibits negative skew over one day periods.

However, over longer periods, cryptocurrencies have exhibited positive skew. The chart below illustrates this for a one week period. Some cryptocurrencies like Ether have more than doubled within a week! Obviously the biggest loss one can experience is everything (-100%) so the potential for more than doubling in price (>100%) creates positive skew.

We want to reiterate our previous concerns that cryptocurrency prices are subject to frequent crashes. Exchanges like Mt Gox have been successfully attacked by hackers resulting in total losses for many investors (see examples below – source http://unenumerated.blogspot.com). For this reason, many might rightly question our characterization of cryptocurrencies as having positive skew. We agree that extreme caution should be exercised when considering this type of investment. The recent run up in prices has led to the creation of many altcoins and initial coin offerings that we believe are in many cases a complete skam. We talk about this here.

There is nothing safe about cryptocurrencies at this time. Anyone thinking about investing should do their own research, consult with an investment advisor, be very skeptical of any anonomymous blog (like this one), and would be wise not to expose themselves to more than they could lose completely!

—

In conclusion, we are in search of positive skew because traditional assets such as stocks and bonds, which generally exhibit negative skew of short we think periods, are very expensive. We discuss this here and here. In this type of environment we believe that having part of our portfolio in assets that appreciate under stress can help improve our return/risk ratio. That said, investments that exhibit positive skew often do not exhibit positive expected return. In order to make money trading these investments one, therefore, needs to determine when to sell. This can be very challenging in practice which is why most people (if not the vast majority) are probably better off not attempting it.

—

Feel free to share your own thoughts on how to find positive skew. There is no better compliment you can give us than your thoughtful criticism. You can reach us at intuitecon@gmail.com, or follow us on Twitter @intuitecon

Sincerely,

IntuitEcon Team

—

Disclaimer: IntuitEcon Team owns, from time to time, every assetclass mentioned in this article including stocks, bonds, Swiss Franks, gold, oil companies, Bitcoin and Ether. These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Talk to an investment advisor (which we are not) before making investment decisions, and be very skeptical of anonymous blogs (like this one). Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.

$GLD $IAU $ETH $ETC $BTC $XTC $SPY #Ethereum #Bitcoin #Ether