What Happens When Markets As We Know Them Cease to Exist

Bloomberg reporter Sid Verma. So Sid, you're filling in for Joe today. That means that we get to talk about whatever we want basically, right, definitely, I mean, yeah, let's be postmortem and talk about anything, all right. So, speaking of postmodernism, I have a complaint, and it's it's aggrievance of mine, which is, you know, you know, when other people tell you that you should pursue your dreams. You'm talking about the positivity industrial complex that runs America. The

same page. I wasn't quite talking about that, but you know, like, if you want to be an actress, you should try to be an actress, that's like the classic one. Or if you want to be an astronaut, you should try to be an astronaut, and then you always hear these big success stories from all these people. Right, of course, it's awful. There's a word for it though, Right. I believe in managing expectations, So I wish that I fail,

and then if I succeed, I'm pleasantly surprised. Okay. But the fact that we focus on all these celebrities who have succeeded in life and they're sort of our base standard. There's a concept that we use for that, and it's called survivorship bias, right, And that's basically the mistake we make that by concentrating on the people or things that survived some certain process or situation that that's kind of like the norm, right, just because they did it, they're there,

of course. Yeah, losers don't matter. That's that's how the whole world is framed winners. Right. History also a classic example. Okay, so, believe it or not, that concept can also be applied to the markets. Yeah, I guess create a destruction of capitalism is another way of putting it. I'm trying to be really alpha male here and I'm gonna ask Simon, why does it matter? You know? You know, survival of the fittest destruction of capitalism. Why is this a problem?

That's what I'm going to be doing. Well, you just give away our guest. We have the perfect person here with us to talk about survivorship bias. It's Simon Hendrickson. He works on the multi asset team of First State Investments, and he has authored a fantastic paper all about this topic. Awesome, should we bring him on? Definitely? You already be zump to me. I scooped you. Okay, all right, Simon, thank you so much for joining us today. Thank you for

having me. So I use that example about us focusing on successful celebrities as the sort of baseline norm um. Do you think that's the right way of looking at survivorship bias. I think it's a pretty good way of looking at it. In finance, you often hear things like equities are going to do better in the long run, and there are certain managers and fund managers who are

celebrated for their ability to beat the market. Well oftentimes while we miss all these really really big events that either destroy whole markets or as you say, sometimes people are just lucky. So if we look at equities over the long term, well, What people often mean is that the US or the U K's equity markets or developed markets have done really well. But what they don't necessarily

mean all the countries that didn't make it. Now, if we talk about fund managers, well, imagine that you have a hundred people were you gave the money and each had to try to beat the market. Inevitably, at some point you're going to have someone who's going to look like a genius. But someone is always going to end

up looking like that. It's just chance. And it's really important not to conflate luck with ability, but also really important to be able to distinguish are we actually falling for the survivorship bias in when we look at investments? And does that mean that you have massive concentration risk in your portfolio? Right? So, when you looked at survivorship bias in the markets, where did you find the biggest or the best example of this? You mentioned equities just then,

so I guess that's an obvious one. Well it is, But if we look back, some of the some of the really interesting event especially through history, has actually lippen where you had catastrophic events. So my favorite is probably back in nineteen seventeen where we had a revolution. Lennon took over from this artist, and after when World War

One began the markets closed. Then if we look back over the last fifty years before they actually closed, Russian equity markets did remarkably well and they actually produced pretty good returns. What what one happened? Equity market shot Everyone thought that okay, when markets open, we're going to go back to to the way they were. They opened up up. You had two months of trading before the Russian Revolution where where the communist expropriated all equity holders, so it

actually went to zero. I can imagine the investment bank reports at that time where you have, by Russia, we believe that the company's revolution will deliver stability, et cetera. Do you think that's a problem about institutional memory? We forget this um Financial market participants are basically forced to be have unrealistic assumptions based on data that's effectively massaged. I think it is because remember, at any point in time,

nobody actually knows what happens. So if you have a let's say we know a probability of something happens, and let's say it's seventy If you bet on the seventy and it actually comes out, you're gonna look pretty smart. But it doesn't mean that it was a good idea not to protect against the last. So that just because something happened doesn't mean that you were an idiot for

thinking the opposite. The problem is if you say things like equities will always perform over the long run, you end up having some thing's like Russia in your portfolio if you don't know how to correct for that. I hate to use these terms, but um, how would you distinguish this concept from tail risk and black swan event? Because I think a lot of people obviously very accustom to those terms, um, and they were bandied around during

the financial crisis. But how is this conceptually different? I would actually say that this is a property risk, a proper catastrophic event which we don't know could happen. So if we go back to our old friend Donald Rumsfeld and the known knowns and unknown unknowns, if we look forward, this is an unknown unknown something Where we look backwards in terms of Russia, we knew that happened. But if you remember, you need to correct for these type of things.

So say that you analyze a portfolio of world equity markets. If you don't correct for all the constituencies that fall out, all the companies that go bankrupt, you're going to have a concentrated portfolio of all the really great companies. This would be like if you knew that invest your money with Berkshire had a way forty years ago, of course you would do it, but at the time nobody really

knew this was a good idea. But I do think that survivorship it is actually a proper, proper tail risk event, and it's something where it's very hot to protect against going forward. But if you and if you don't know what to look for in the past, So this is one of the areas where you can have a history is really really important. But it's also important to have very long time series. Yeah, so I think that's an

important point. And I really like the Russia example because if you think about it, you know, if you were a European investor in the early nineteen hundreds, Russia was one of the great powers, So why wouldn't you invest in that market? And you know, the idea that the market was going to close down at some point was, as you put it, a complete unknown unknown. But realistically how do you protect yourself against that? Is it just about having a wide variety of assets in your portfolio.

It's about having a lot of different risk drivers and making sure that when you look at your portfolio that you don't just look over a short horizon, but you so look at what can actually happen. So, say the idea of having what has been very popular over the last sixty forty years, having a portfolio which is six

equities and bonds. Now, this has been a uniquely optimized portfolio over the last forty years, and market conditions have been great because one you started from a valuation point where equities were really cheap and bonds were really cheap, so you wrote the cycle. You also had the added benefit of having negative correlation between the two. So when equity fell, equities fell, which would be seven, you had the dot com bubble, you had the Great Financial Crisis,

you actually saw bonds doing really well. That has not been the case historically. So if you go back and take England, and England is one of the good examples because we actually have great data going back almost five years, because the Bank of England is it's good at collecting data. Then for three D and fifty out of the last four hundred years you actually saw a positive correlation between

bondson and equities. So all the times of say wars both actually behave like risk assets and they were not good offsets. That's something that's hard for people to get if all you've lived through, like me, were the last twenty years of time where it was conventional system that bonds and equities are good offsets. But knowledge to work and grow your business with c i T from transportation

to healthcare to manufacturing. C i T offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at c i T dot com put knowledge to work UM. Obviously, you know in the emerging market space, if fuel you get, you fall out of benchmark industries, if you don't have what the rating agencies want you to have, if they look at institutional strengths and so forth.

So if you look at all those indicries, a lot of those sovereigns are those were strong institutions UM, and so you forget that. Actually there are a lot of reasons why strong corporate structures matter for equities. That actually matters to have a rule of law, and it seems like institutional memory. Just to heart back on my my point, because um, it seems to be forgotten by a lot

of investors. UM. So I guess it's just really hard to kind of correct that impression because on day to day trading, UM, you could go mad if you have to revisit every single prior that you have. So I think that's a very good point because what we've had in terms of survivorship bias here is that the countries that have done very well have in general been the countries that have had strong institutions. There's a whole strand of literature in the economic history body where the overarching

theme is that institutions really matter. And I tend to make fun of them a little bit because it seems a little bit simplified and well because obviously they do, but they actually do. And this is obviously pretty important as we look forward in terms of countries where we now have big institutional changes. So think about Trump. Is this just something that's going to happen and he's going

to disappear in four years? It might be. It also might be that the institutions have dramatically changed, and this is a structural break is the fact that Brexit is going to happen a structural break for the ur Zone, which as far as we can remember back has moved forward in terms of integration. If this is a break, then are we starting to having to look back to history where European countries weren't trying to help each other, but we're actually in conflict. And that's the sort of

thing where it's very important to know history. It's very important to know that if you don't take these things into account when you build a portfolio, oftentimes you end up with concentration risk. And it's not enough just to say, well, US has outperformed US equities have outperformed basically everything else over the last hundred years. Well, yes they have, because they were the best, most democratic, most best well functioning country that has been there. So you end up having

to look at a variety of things. And one of the things if you go from backward looking forward looking is well, these type of things rule of law, it really matters, and especially when you look at em we know that it matters for equity returns, for bond returns, and should we think about this where we live now. I mean, if you look at Venezuela. It's everyone knows that you're going to have to take appropriation risk that they're actually not gonna gonna pay you back, or they

might not just expropriate some of the assets in the country. Well, it's not really something that people have done. Developed markets only think about. And one of the things that worries me is that the people who were really really worried about what has happened over the last year I tend people who tend to do emerging markets or history. Yeah,

so that reminds me. But we did see at least one rating agency talking about developed countries exhibiting more emerging market risks, right, said, I seem to remember you writing a story about that. Yeah, I mean, it was an interesting statement from SMP stating the fact that institutional strength has been one of the biggest anchors for high sovereign ratings amongst developed markets, along with you know, strong capital markets, um,

et cetera. But now they say the strength of institutions and the rule of law is now under question because of this rise and populism. Um. I think your point of earlier kind of really struck homes to me because it seems that emerging market investors get much more concerned about developed market risk than vice versa. And it seems um like, yeah, that's part of that point, the survivorship,

but it seems to be extremely important. If you have that perspectively, you understand the historic anchors for capital market performance. And I think it's important to say that I don't know what's going to happen, but I know which risks are important to look for. So it might be that the next hundred years are going to see amazing US

equities returns. But the situation is different, and just because something happened over the last hundred years doesn't mean that it's going to continue because, as we know, US were the hedgemon and they actually won. Whereas if we are in a situation where we've seen lots of these things happen over time. So another one of my favorites is back in the French Revolution when the Jacobeans came in

and they exprobriate a lot of church land. You have other episodes in the twentieth century in Shanghai the communists expropriated all of the equities as well, and you do see these types of events. Well, what strikes me is the fact that just looking at some of the data, US assets have outperformed in real terms, nominal terms, risk adjusted returns for the last one hundred years. So this is American exceptionalism in capitalism. And how dare you question

American exceptionalism? Would be the naysayers to your narrative, which is fair. But what I would say is try and wind back a hundred years, who were going to be the world hedgemon at the time. And then if you look at returns for Germany versus the UK versus Soviet Union, you end up with a discrepancy that is so big that it's actually a hard to measure because there can

only be one winner. And over the last hundred years German bonds you would have been returned basically nothing in real terms, whereas you've had really good performance in in the US. So the thing is, I'm not actually questioning what has happened and the conventional wisdom as a world over the last hundred years, just saying that it's very important to look at these big episodes, whether it's going to be political revolutions or hyper inflation, currency mismanagement, or

potentially wars. Look at those see what did capital markets do in those type of situations, and how does that actually affect affect the portfolio. And this is not something that is likely to happen, but it's a useful exercise for your mind to say, well, let's assume that the world is not gonna be like it was over the last ten years, what actually happens and do we have

too much risk into one scenario. It's kind of like, um, a gloomy scenario though, isn't it, Because if you're taking a really really long historical time frame of the world, then you're almost ignoring whatever progress you might claim to have been made over the past, you know, fifty years or a hundred years. Is it's almost mean reversion to

what the Middle Ages. I don't know absolutely, if you read someone like Pickeoty, you would actually say that the last fifty years worth the anomaly, and that over time we've generally seen that it is the high owners who take most of their money home and you have massive inequality. Now I'm not a massive fan of his theories, but his data is really good and if you go back and and see through history, we actually have had it

very well over the last hundred years. I mean, I find this framework really useful, not just for thinking about big global macro events and big terrorists, but just on the simple concept of unrealistic assumptions. I mean, you've got pension funds that are targeting, you know, UM, high inflation adjusted returns UM, and they're complaining that they can't fulfill these return targets. But it's not just because government born

yields are are low UM. It's because UM that it's all based on benchmarks only UM cover the winners UM and the losers always consigned to the dustbin of history firstily and if we make it a little bit more tangible. A lot of people have said that global financial crisis looked a lot like the Great Depression. I think that's a fair comparison if you go back and look at as it returns. Let's assume that the UK and the US are actually the template going forward. Bond returns were

really bad in nineteen fifties. You came from really really low yield and they rose, which meant that equities did very, very well the bonds didn't. We live in a world where we've been used to double digit bond returns, and

at these levels, it's just not possible. Now, I don't think we're gonna necessarily see bond deals that are going to be double digit any anytime soon, but just the return assumptions from say, pension funds, as you said it, it's a little bit hard to imagine those actually coming to fruit. Do you have any simple the for people who mount the classic argument that this time is different, you know, like secular stagnation will change bond returns or

alter portfolio balance, any sympathy at all for them. Now, I'm a historian economic historian by education, and most things have actually happened before. At any point in time, you usually had people saying this time is different. Sometimes it's true. Mostly those can be found in terms of technological progress, in terms of political cycles, economic cycles. Things have a

tendency to repeat themselves. And when people say that this time is different, well, this time was actually not that different. You had the Great Depression, which was a pretty good way of looking at the global financial crisis. Bond yills did more or less what we would expect them to do, and you have so many countries in the world that it's not unlikely that we're going to see hyper inflation going forward. Is not unlikely that we're going to see revolution.

We have wars all over, so I have sympathy that things are not going to be the exact same, and you need to be very careful how you actually look at history and use it as a guide. But in terms of things are great, and we are now in the most peaceful time. As one author put it when he said that we haven't seen a big war in since the Second World War, I think that's misunderstanding what

it has actually driven history. And if we want to tie this back to survivorship bias, one thing that I haven't mentioned is that the most dangerous thing is that all the things in history which we can't measure, so oftentimes the thing that really drives survivorship bias are either records that are lost, people who have died, or people have disappeared. All well used to say that history is

written by the winners. This is very, very true. There is not really any way to measure whether a conquering country three back three years expropriated um, expropriated some assets and never told anyone about it. Now we have a lot of these stories, but I'm sure there are many more, simply because nobody is really left to tell them and if nobody documented them, well, even if they did. Try to tell your friend a story and then see when that story comes back to you from another friend how

much has changed. It's changed quite a bit. Usually, Well, should we leave it on that? I feel like we go into a dark place when Joe isn't around. Yeah, I'm actually too scared to ask a follow up question to Simon because I'm I'm worried about We can leave things, but it's probably gonna be okay. It's just important to be be like knowledgeable about these risks. And I'm not saying that we're going to see a world things world extinction event, but managing history. History has told us that

managing expectation is is not the worst thing you can do. Okay, Simon Hendrickson from First State Investments, thank you so much for joining us, so said, Have I scared you away from the ad Thoughts podcast forever? Yeah? Maybe, I'm pretty I think this is a useful framework to think about the end of the world. Stroke tail risk, stroke equity market, stroke, mutual fund performance UM. And I was very skeptical when I heard of the concept because, as I said at

the you know, the outside. I wanted to be really alpha about it and say, why do you lose this matter? This is what makes capitavism is great. But yeah, you realize that history really does matter, and it really flatters

the winners. It does make you think about core concepts in investing, such as you know, if you're sat in a developed market, you're probably mostly buying developed market assets and should that be the case, And if you really want to catch onto the next big thing, it might not be the current big thing, right, Yeah, and that totally can change. But if you look at the data over the long haul UM, it will massage and airbrush out all those lessons. And I thought that Simon's point

that we don't really know what happened. We don't know which sovereign exprose created what assets, we don't know which companies have failed because of all of the data. When you look at it over the long haul, UM doesn't provide those lessons. And I feel like institutional memory about the importance of governance and structure and so forth is it falls by the wayside. So yeah, it's a really

great framework. Actually, I'm going to think about this much more. Yeah, and maybe there's like a holy grail historical documents somewhere that would turn our entire viewpoint of markets and finance on its head. But it's hidden away in you know, like some ancient temple. Oh, you're saying that yield stone don't move inversely tour prices and bond markets. I think we're going to go and have to search for that ancient text. All right, let's leave it there. I'm Tracy Allowit.

You can follow me on Twitter at Tracy Allowit, and you can follow me on Twitter at under school sid Farma, and you can follow Simon Hendrickson at Simon h Underscore d K. Put knowledge to work and grow your business with c i T. From transportation to healthcare to manufacturing. C i T offers commercial lending, leasing, and treasury management services for small and middle market businesses. Learn more at c i T dot com Put Knowledge to Work