It pays to eat at grandma’s
The world is a random place. It is only a couple of months into 2014, and the stock market has already reminded investors of its capricious nature.
Investors cannot be guaranteed a repeat performance of the impressive investment returns they enjoyed in 2013.
As recent events in emerging markets and with the Federal Reserve remind us, volatility is an embedded feature of investing. Yet investors do not need to predict the future to manage risk appropriately. Instead, they need portfolios that are resilient regardless of the scenario.
One of the ways to build resilient portfolios is to emphasize convexity. Convexity has a tendency to sound overly technical, but in reality, it is as simple as Grandma’s cooking. Why do you go eat at Grandma’s week after week? Because the food is always pretty good, and sometimes the dishes even prove to be exceptional. In other words, there is limited risk of a bad dinner (downside) while there is a good possibility of eating something great (exposure to the upside). The opposite of Grandma’s dinner would be a meal at the local fast food joint, where no dish is truly special (limited upside) and can be hit or miss (lots of potential downside).
Investors do not need to predict the future to manage risk.
Companies exhibit these qualities, too. Those with stable and recurring revenues, or significant cash positions on their balance sheets, tend to have less risk to the downside. If something goes wrong, they are in a better position than a highly indebted company with unknown future sources of income. When these companies also have the potential for significant upside, they exhibit convexity. A portfolio made up of companies with these characteristics is much more likely to protect capital during negative events, while growing it during steadier times.
In an uncertain world, it is heartening to know that some investments demonstrate convexity – just like dinner at Grandma’s.