Mawer Funds: Downside Protection – The Unfathomable Is Not Impossible

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Mawer Funds first quarter 2015 discussion paper titled, “The Unfathomable Is Not Impossible.”

I was six or seven when I first came across Alice Through the Looking-Glass in one of the rooms at my grandparents’ home. While the adults spoke over tea, I would sneak away into the backroom and lose myself in a world of peculiar characters.

Mawer Funds: Downside Protection - The Unfathomable Is Not ImpossibleOne sequence always stuck with me. It occurs shortly after Alice meets the Red Queen and asks her age, to which the Queen answers: one hundred and one, five months and a day.

“I can’t believe THAT!” said Alice.

“Can’t you?” the Queen said in a pitying tone.

“Try again: draw a long breath, and shut your eyes.”

Alice laughed. “There’s no use trying,” she said: “one CAN’T believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was your age, I always did it for half-an-hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

– Lewis Carroll

It is a subtle exchange that can be easily overlooked. I love it for the outlandish proposition it makes: not only can we think about impossible things, we should do so on a regular basis.

Like Alice, investors today find themselves in a strange world. In the last year, the price of oil halved, Russia invaded Ukraine, central banks responded to the threat of deflation with massive stimulus, and the risk-free rates of Spain, Italy and Portugal fell below the equivalent yield in the United States. Even the yield on some of Nestle’s bonds turned negative. In short, many events transpired that were previously considered impossible by some in the investment community. This underscores that much of what is considered “unfathomable” is clearly not impossible.

But is there some way to practice thinking unconventionally? Can we train ourselves to think impossible things like the Red Queen?

In our view, the advantages of building this skillset are significant; not only is this type of thinking important to protecting against the downside—by helping individuals avoid large losses from negative scenarios—it is also critical in order to optimize the upside—by allowing people to make the most out of life.

When we open our minds to a wide set of possibilities—including ideas that initially seem impossible—we make it easier to put the odds in our favour over time.

Mawer Funds: Considering the downside

It was 2:58am when the electric clock stopped working. Jack lay awake, awoken by what he thought was thunder. The noise soon returned but this time with violent vibrations. This wasn’t thunder. He quickly ran to his wife, Olive, shouting, “Grab the children and get out!”.

Torrential downpours throughout the summer had saturated the hills creating a loose layer of soil that hung tenuously to the mountain. Tragically, it all came down that night. Huge mounds of mud detached from the bedrock and came cascading down the mountain, gathering debris and destroying everything in its path. Jack’s mobile home lay directly below. As Jack and Olive scrambled to grab their children, a boulder the size of a small pickup crashed through their living room window, inches from where one-year-old Jo-Ann lay sleeping. The mountain above was coming down in a giant mudslide.

Only Jack and little Jo-Ann made it out that night; Olive and the four older children were lost. The community shuddered at the terrible misfortune. While the 1973 mudslide brought destruction to Harbor Breton, Newfoundland, most people walked away unscathed; only my great-uncle Jack lost a child. And he lost four.

The mudslide that took Jack’s wife and children may have seemed like a highly improbable event to those in his community, but the more facts we learn about that evening, the less far-fetched it seems. Not only was Jack’s home situated at the foot of a mountain under loose soil, it had rained for forty days straight before that fateful night. One doesn’t need to be a geologist to suspect that on the thirty-ninth day of rain, the risk of mudslides was elevated. The magnitude of Jack’s loss was enormous; but the probability of a mudslide was not altogether incredible given the conditions.

Negative events happen. They happen more often and with greater magnitude than we usually anticipate. This is why we must spend time considering the downside and building our resilience to it. Unfortunately, the majority of us seem to avoid actively considering the downside. This leaves us exposed to both “black swan events”—a term coined by Nassim Nicholas Taleb1 referring to the rare and unpredictable—as well as the large swath of fairly normal negative occurrences.

See full PDF below.

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The post above is drafted by the collaboration of the Hedge Fund Alpha Team.

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