Why even our best Models Fail Us: The Illusion of Control Over Randomness

 IMPORTANT DISCLAIMER

The conversations in the “MOST important thing Podcast” are evergreen in nature meaning the content is purely for education and information purposes only. Whilst individual stocks may be mentioned in the course of this interview, neither the hosts or the guests make any implicit or explicit recommendation to purchase or sell these stocks. This is NOT investment advice. You should seek professional financial advice before making any decision relating to your hard-earned capital. Discussion relating to the valuation of the US market and/or stocks may be out of date. The host or guests take no responsibility for errors in the transcript or recording.

Most investors are blind to the hidden risks lurking behind their seemingly safe bets — and missing out on epic opportunities in the process. Imagine understanding the true nature of black swan events, fat tails, and market misconceptions so profound that they can reshape your entire approach to investing, risk, and strategy. In this eye-opening episode, renowned finance thinker Diego Parrilla takes you beyond the headlines and common wisdom to reveal why many of our biggest assumptions about markets, volatility, and diversification are dangerously wrong.

Transcript

SPEAKER_04 0:00

And Yulkov Control, unlike quantitative easing, quantitative easing is about, hello Mr. Powell, here's a hundred and twenty billion a month, go and spend it. Um and he bought whatever he wanted, bonds and affected prices of things. Yuke of control is different. It's like, hello Alan, the 10-year treasury is not gonna go worse than five percent. Why? Because I said so, what are you gonna do about it? Print infinite amount of dollars to to hold it. It's a it's more about knowing what not to do. So if someone is now okay, who do you want to marry? It's like, I have no idea, but I can tell you who I do not want. So that's what I learned. That's what I learned from some relationships where you're like, I I don't really know what I want, but I can tell you exactly what I don't want. And so I think you can improve the average and you can make your day better by simply knowing what to avoid.

SPEAKER_00 0:47

Welcome to the Most Important Thing podcast, where we speak with the best and brightest in finance, economics, investment, and geopolitics to bring you the truth about what's driving the global economy and financial markets. Every week, our chief market skeptic, Dr. Alan O'Sullivan and former government minister Ivan Yates sit down with a global expert to provide invaluable lessons from a lifetime of markets experience. Economic expansion or recession, market highs or underlying vulnerabilities, AI dystopia or just the next bubble, escalating geopolitical tensions, or simply the new global order. These are deep conversations searching for truth and practical investing strategies to improve your chances in this uncertain market environment. To optimize your learning experience, visit our learning hub at the mitpodcast.com, where you will find the latest guides, investment ebooks, and a community that focuses solely on expert insights. Enjoy the show.

SPEAKER_02 1:36

Now, today's episode of the most important thing, we are off to Madrid. And we're gonna speak to Mr. Diego Perea. And he is the CIO, the fund manager for a fund called Quadriga. And he is going to talk to Alan about what?

SPEAKER_01 1:54

Diego, again, is another very interesting character, okay? Uh has an interesting background, is actually an engineer, started off as a mining engineer, has a number of mining qualifications, okay? But Diego is a practitioner, he's got skin in the game, he's managing money. Uh again, takes a contrarian view, is is very aware of the monetary policy mistakes that have been made. And what I mean by that is during the interview we talk about the excesses of central banks. Whenever there's a problem, the playbook is very simple. The central banks write to the rescue, print money. And that has that's okay in a crisis, but it has been abused. Back to Dr. Lacey Hunt, when you abuse one of the factors of production, you get uh you get problems like negative interest rates with lunacy. It created an all-a whole load of imbalances. So so really it's it's it's it's back to that. And then looking at other assets, he he he makes a great case for alternatives and his own funds as well.

SPEAKER_02 2:55

Asset bubbles. We've talked about this and how uh quantitative easing uh can lead to asset bubbles whereby they become overvalued. Does he address asset bubbles?

SPEAKER_01 3:06

He his very interesting framework, okay, in terms of talking about bubbles and the anti-bubbles, okay? And this is his framework for allocating assets. So a bubble is easy to understand, okay? So he he his view is that let's say the S P 500 is a bubble because of cheap money and money flows into has inflated the value. But there's also an anti-bubble, and that is assets that are unloved, that haven't got capital. Like gold stocks, for example. If you look at the SP 500, that's the index of all the shares, top 500 companies in in America, okay? Dominated by technology stocks, as we know, dominated by the Ministers 7. But gold uh companies, for example, or mining stocks, for example, are only 2%, 2-3% of that whole index. So this is his framework where the bubble is the tech and the anti-bubble is the mining stocks. Okay? And they're both related to each other, they're both feeding off each other. So his framework is yes, the bubble is obvious, but the anti-bubble is also obvious. And the anti-bubble is what you should be buying because that is related to what you should be selling, if that makes sense.

SPEAKER_02 4:20

What are the type of misconceptions we should watch out for in this interview?

SPEAKER_01 4:25

The misconceptions are that central banks uh and governments are always going to save the day. Okay? They have a they have a point where it doesn't work. Could the solution be worse than the problems? Well, the solution always was, okay, the basic thing with central banks was if you get inflation like we got in 2022, you raise interest rates high enough that it kills aggregate demand in the economy, slows down the economy, like you said, kills the patient, okay? But that's the design. You know, we're in 2025, and that's the best we can do. That's a kind of a common theme throughout this series is the best we can do is just kill aggregate demand, cause a recession, that beats inflation. Okay, but what if central banks are no longer able to write to the rescue? What happens then? And that's where some of Diego's main themes spring from.

SPEAKER_02 5:19

Okay, let's get into the conversation then between Alan and Diego Perea, uh, who's based in Madrid, and we'll have a chat again after this.

SPEAKER_04 5:36

I love the concept of Black Swan. I think uh Taleb is uh has been very influential and Carl Popper and all this mindset. I think his contribution is towards you know, as humans uh we have this ludic fallacy of pretending we understand probabilities and underestimating the the fat tails and uh not uh and and understanding the randomness. You know, I teach at Imperial College and we talk about you know stochastic processes and randomness. And I I think terrorist attacks or natural disasters or things are within the realm of probabilities of things that could happen. Um and they are extreme events. They you know given our own standards and probability distributions and mindset of normalization, uh you have these these concepts where uh you know when you windsardize a distribution and just take out everything outside of the the the 1% just to have a nice neat uh stuff. And and uh the concept of a five-standard deviation, ten standard deviation, fifty standard deviation looks crazy because we immediately uh it's the causality is reversed. You know, we built a model in our heads that says the probability of that happening is is impossible because you know it would require it would be once since the dinosaur age. And and and and Taleb is more saying, like, are you guys out of your mind or what? I mean, we've had uh an oil futures market for whatever, 30 years, and you're making extrapolations or uh for for thousands of years and pretending this is never been seen before. So I think Black Swan is really a more philosophical human question about you know how you know uh the models we build in our heads uh can actually uh lead us and mislead us into into believing that we have this sense of control, this fooled by randomness, you know. So I think in that sense, when when what you touch on whether there's some sort of relationship, I think the thing that Taleb does is is what I love about the definition is uh the of course, you know. It's like everybody thought it was impossible, yeah, but now everyone's of course the you know there was a terrorist attack attack in in the Twin Towers. Of course it was going to happen because of, you know, X So I I uh there is in potentially a link, but I I think they're two slightly distinct um approaches. You could you could rationalize the uh the black swan, and that that's part of the definition of of how the the black swan is is defined. So it's uh events, three conditions, events that are um you know extremely large, uh that nobody sees coming, but everybody thinks is obvious after the fact, right? And we can talk about the pandemic and others. So back to misconceptions, I think it's easier than that, but I and I agree with you. Uh the way I would put it is show me the misconception and I'll and I'll tell you the bubble and anti-bubble. Uh and and that our relationship, that that you know, three-legg relationship is somewhat like a non-arbitrage. There has to be in in in one way or another. And I'll give you a more recent example, just to maybe uh again to throw some some stuff. So let's look at NVIDIA, right? And not long NVIDIA and the uh deep seek event, right? So if we ask ourselves, and again, I'm just uh uh in no possession of the truth, I'm just uh humble guy making some some uh some thoughts, uh sharing some thoughts, but to the extent that uh the question was, is NVIDIA a bubble? Uh and we go back to the earlier point on uh uh time will tell, right? Is it a game changer thing? How does the world, whatever? So if we said, okay, what are the beliefs and what are the misconceptions with NVIDIA? Uh I think NVIDIA valuation has a lot of merit. There's tons of things that are game changers, perhaps, but there are plenty of other things that were uh widely accepted uh beliefs, such as I'm the only guy who can do this, uh I have infinite demand, I have infinite margins, I there's no competition, uh, I can do whatever. You have all these different pillars that build this uh incredible valuations, and suddenly these guys come and say, Well, I did this with uh five million dollars. By the way, you can use your children's computer to do this kind of stuff, and and people look at each other and say, but I thought that uh and so the entire if you're rational about it and you had your thesis, you'd say, Okay, these pillars stand, these pillars do not stand, and the fair value of NVIDIA is now X. Okay, and you continue to adjust. But that misconception and that bubble and that anti-bubble and that relationship is is alive. And and I think the uh you know Soros again uh talks about this this idea of of uh the period uh uh the where the dawn you know where the conceptions and misconceptions coexist. Um and and and it's normal. It's not like uh uh Deep Seek came up with something and everybody boom uh light bulb went on, and the entire universe said, Oh, uh now I understand exactly what happened, and this is the fair value. It's like everyone's trying to figure out. So in that process, you know, things things to move. But I love the concept of black swan. I I think fat tails is uh but then ultimately, and and and and you think about misconceptions, the other big point that links them is is is risk primia, is uh you know, a concept I teach to the students, is is the relationship between, let's call it, real-world probabilities. If we had a crystal ball and we knew exactly what the outcome of um the real probabilities, which is the ludic fallacy. We we we as humans we try to think that there is such a thing, which it's not. Uh it's random. Uh, there's an element of stochastic randomness. But what you can do is you can go to the markets and say, okay, what is your probability distribution? And and you look at the options markets, you look at the correlation markets, and you can actually construct an extraordinarily accurate uh view of what the world is predicting today. And that's what I do with in in you know what we do on the quant side, and we're able to uh it's not that we have a crystal ball, but we have uh exactly access to the crystal ball of the market to say what are you predicting? And I think that's where perhaps things get disconnected. So the fact that there might be uh black swans doesn't mean they're a good investment on themselves or a bad investment. It depends on what the market is pricing, how the market is the supply and demand for these things. And so there's a lot of art and science on on identifying these opportunities and uh and and and and basically you know uh generating contractual and and indirect ways in which we achieve our objective. You know, I think we need to uh fall in love with the problem, not the solution. This is one of my mottoes in life. You know, I I think the biggest uh problems in corporate world history, the biggest uh blow-ups have always been people who fell in love with their product, you know, with with their solution, not with the problem. Think of linking the story back to to oil and OPEC, right? In my book, I I said, look, uh OPEC and oil have been extraordinarily successful. Uh and and the misconception at the time was that um, you know, the book was called Opportunities from the End of Peak Oil. Back in the day, you know, when we published that book, people were like, Are you crazy? Of course, oil is gonna go to 500 because there's only enough barrels and we're gonna run out. And I was like, look, um the reason OPEC has been so successful, and the one of the big misconceptions in the system was the belief uh that uh OPEC was successful because it was uh an oligopoly, i.e., I control the supply, I control the price. And one of the conclusions that I I you know, together with my co-author, but we we uh I reached is um OPEC's success and oil success is not so much an oligopoly of supply, which is a necessary but not sufficient condition, it's actually a monopoly of demand. And turned out that it's transportation demand. So for decades, you know, our cars or buses or trains or ships, they were all fueled by crude oil derivatives, gasoline, diesel, jet, and there was lit virtually zero competition from from for transportation. So as uh the world globalized and transportation demand increased and and you were the only game in town, that control of supply allowed you to do that. But then you wake up to a world where you know technology, LNG, you know, you start fueling trains or buses with LNG, with electric cars, etc. We've created competition for transportation demand, and that's how the whole thing crumbled. So again, I put a thesis out there before it happened. Um and and and as things happen, it's it's pretty obvious after the fact. But it it does come through this thesis analysis and trying to, you know, not take this uh beliefs as gospel, you know, just to try to challenge the why is this the case and and that causality. And and and it's it's fun. I I love the fact that you you're calling me detective because maybe I am. It's like, but why did that happen and and and and how am I going there, right?

SPEAKER_01 15:53

I think you are. You're a chess player, you're a detective. You're looking, you're trying to see around corners. I mean, I I'm I'm looking to the next major misconception, which has a huge impact on Irish investors, European investors, you know, global pension funds. A fixed income works in a disinflationary environment, but what about if it what about in a stagflationary environment? Um, you know, what are the implications? I suppose for you it's good because you mean there is a massive market for what you do, but the 6040 just doesn't work anymore. And agree.

SPEAKER_04 16:27

And and I think this is one of the natural uh conclusions from exactly what we're discussing. And um let me put it in uh in in different ways. So if we have some teenagers listening to this, I'll say, let's assume that this is a video game, right? Level one of the video game is can you make money in nominal terms? And what I mean by that is, hey Alan, here's a hundred Euros, uh, make me money. And you come back with 103 euros and you say, Hey Diego, I made you three euros nominal. And and that works in a world where inflation is negligible, which is pretty much the game we've played for the last few decades. I mean, I I think it would be a fun exercise to look for um, you know, in the developed market world, you know, uh just do a word count of of inflation in in from 2000 to you know for a big part of of uh of history, other other than uh the obvious cyclical aspects of oil is overheating and whatever. But uh the 2% inflation target, uh that that frog in boiling water, it's again made inflation be somewhat negligible. No one would come back to you and say, yeah, uh Alan, you made me three, but inflation is 2.7. In reality, you just made it me 0.3 because benchmarks are nominal, we think nominal. Inflation, by the way, your inflation is different from mine, different from anyone in this in the listening to us. Um so in that sense, level one, making money in nominal terms is work for a while. And fixed income works because you know, even if I'm paying you in Japan 0.1%, uh it's better than deflation, of course. And and so people were kind of fooled there. Now, level two is can you make me money uh in real terms? And I'm not saying real uh after CPI or some sort of official uh BS uh inflation is can you actually preserve my capital? And once us frogs realize that uh that game, that effectively to make money in real terms is much harder, and in fact cash and fixed income um uh in many cases and many parts of the world is deeply into uh into uh that negative territory. Uh we start jumping off the ball. And this is driven, you know, why why did the the frog jump? There are two inflation has two big dimensions. Number one is inflation itself. Two plus two equals four. You print, you know, 10% of your monetary base, and let's assume that everything, you know, it gets impacted uh linearly. That would be a very naive way of how money uh printing impacts the world. But let's assume that that's the pace at which gold should go up. Okay, I I I I dilute the monetary base and all else being equal. I I can't print gold, so it'll it'll go up. Uh but the second dimension is um inflation expectations. This is us frogs will jump off the ball because we basically saw, oh, uh the temperature's gone up by a lot. And I, you know, but if if they tell you, don't worry, the heat is off, uh, it's uh was a one-off, it's temporary, it's uh uh you know, some frogs might stay in. But when you realize that, you know, the the inflation expectations, the temperature is going to increase like crazy, will start jumping. And when you jump off fixed income and yields start going up, and you have a problem because your outstanding debt is just too high. And that starts to create reflexivity problems. I mean, think about what your your beautiful country and and mine went through in the European crisis, right? Uh Spain was sort of the last piece of the dice uh of the of the domino. Um whereby once the at the time, the 10-year um bono was a 7.5%, that was considered the point where the amount of money that goes into service in debt uh it's so high that you have no room to do anything else, and it spirals into out of control, and that's why you know we have to bail out a bunch of guys. And so that reflexivity of the process as as as frogs jump out uh effectively leads to what I think is the biggest acronym for the next decade and you know, to your point on the next misconceptions, which is yield curve control. And and yield curve control, unlike quantitative easing, quantitative easing is about hello, Mr. Powell, here's 120 billion a month, go and spend it. Um and he bought whatever he wanted, bonds and affected prices of things. Um yield curve control is different. It's like hello, Alan, you know, the the 10-year treasury is not gonna go worse than 5%. Why? Because I said so, what are you gonna do about it? Print infinite amount of dollars to hold it. And and at that point, you know, uh and this is where the chess game is being played, at least in my head. Um you know, you have that we're gonna talk about them maybe more detail because it's more complex, but let me finish the framework. You know, this idea of level two and and what it means with inflation, what it means with inflation expectations, what does it mean? With problems that are effectively too big, economies that are too big to fail, and all that stuff leads to this dynamic. And that's where the 60-40 falls, the correlations break apart, and everything else. And level three, and let's not fool ourselves, is taxes. This is how you square the circle. Effectively, can you make money in real terms after taxes? And in particular, wealth taxes. Okay. And the situation is mommy and daddy, you know, they face a problem. They say, okay, let's print our way out. They inflate problems, that inflation creates inequality, social unrest, wars, whatever. And then eventually that inequality creates a super rich, super low. And then of course you're going to go after the rich. And of course, no one's going to complain that you're going after the rich, which you created on the first place, partially through inflating. And then you sort of square the circle by where the governments had this first mover advantage. So they said, okay, I'm going to print the way out. I'm going to spend first. I'm going to repay with lower with the debased stuff. And this is why I think from a game theory perspective, these three levels are there. And we are somewhere between two and three. And but you know, I think Mark Twain said death and taxes, right? So I think in that in that story, we have this dynamic. And to your point, the 60-40 fallacy, the you know, how how are we really solving problems? This is kind of what I keep asking. Is it are we really solving the problem or are we delaying, transferring, transforming, or enlarging the problem? And and what Yield Kirf control does, back to that level two, and what we might be witnessing in certain parts of the world, is we're not solving the problems. We're transforming a credit problem, which is a fiscally uh imbalanced uh bankrupt uh economy, into an inflation problem and and currency devaluation. And this is yet again the same thing we've always done, except that the problems become bigger and more exponential. And so we're now at that point where the frogs, you know, and and this brings me to, you know, in the chess game, okay, move six or seven, because the first thing people are thinking today is if I have a problem with US Treasuries, and at 5% they're gonna have to print a lot of dollars to hold it, and the dollar is gonna go to zero. And I'm like, yeah, but do you want to buy bonds at two and a half? Do you want to buy JGBs at one and a half? They have exactly the same problem, except that the Fed and the treasuries have already taken the hit of their bonds going from one and a half to five. So from a duration perspective, and considering the central bank put, which is really a fixed income put, is not an SP put. A free put by put called parity is a free call. So if I'm loaned treasuries at 10%, at 5% yield, and that yield is controlled, I have a free call, except that it's denominated in dollars. But good luck in the ride of the bund or the bono or the BTP and good luck with JGBs. And good luck with interest rate differentials and the widening that what does that mean for the euro or the yen? So what out of first order looks like a one-way street towards weaker dollar could potentially give bring us into a fork that is much less obvious in what it means on a relative basis, which brings me back to gold. So I've already played this chess game in my head and brings me back to I don't really know where these guys are gonna go, but I think I know where gold is going. And and and that and that will bring us to taxation, etc. But it it's as you can see, it's a it's a fun chess game in in our heads that we need to understand and play through. And uh we'll see how it ends.

SPEAKER_01 25:56

I've looked at gold, and gold has been a consistent you know hedge against you know equity, equity risk during stressed environments. I I I I've no I've noticed, but but also an inflation hedge, right? Not all the time uh equity environments, but it it it has done well. The problem with gold is it's volatile, it has the same so-called volatility as equities, okay? And people say, well, I'm gonna add lots of gold as a defensive asset and reduce my risk. And I know you're very critical of standard deviation as risk. It's not risk, it's you know dispersion around some means. Here's the question: if gold absolutely works, fixed income doesn't work. You know, we get into your false diversification uh message then around I call I I kind of look at a naive diversification. People in 2008, they thought that they were diversified, but they were all positively correlated to growth, let's say, right? So corporate bonds, REITs, stocks all went down together. Is it this is it the kind of the same now with inflation? They're they're kind of uh short inflation. Here's uh an invite for you to tell me how what you do, you know, what will work if everything else is not going to work. Uh what what what's going to work?

SPEAKER_04 27:13

Okay, so uh let me first touch on uh a point you made which is important uh on volatility. And and in fact, I think you brought out misconception, uh which is pretty uh entrenched into our our brains because we tend to associate volatility and risk. We tend to associate something that is volatile to be risky. And let me share with you we haven't planned this, but let me let me see if I can share my screen. We're gonna improvise here. But uh uh effectively I'll show you a point that I I I think it's important. So is the is the point of you know that there are crises are mechanical processes. I call this slide uh Chronicle of a Crisis Foretold in honor of uh Garcia Marquez's book. And effectively what I'm gonna show you here is is uh to elaborate on your point is the impact of of uh volatility correlation and liquidity. And what you see on the bottom left is uh let's say two assets in in gray that are low volatility and negatively correlated. And in blue, you can see the portfolio. And you would argue that it looks like this portfolio is extremely low risk, uh, you know, diversified, and and there's low risk. Let's look at three partial derivatives, you know, all else being equal. Let's just shock um volatility and leave everything else unchanged. And what you see is that as volatility goes up, if correlations remain negative, then portfolio risk increases but relatively marginally. Okay, so but what happens if I shock um correlations, leaving volatility unchanged? What you see is that the portfolio risk is significantly more sensitive to correlation than it is to liquidity on a standalone basis. But what happens in practice is that the increase in volatility compounds and you know polarizes correlation from plus one to everything goes to plus one or minus one. And so as volatility goes up and you start getting your value at risk increases, you get a margin call from the exchange, you start to you know force liquidation and deleveraging, and correlations start to polarize between, let's say, crowded consensus positioning, etc., what you end up is the compounding of volatility and correlation impacting liquidity in through a negative feedback loop. And what you end up having is risk, I love this expression in English, literally off the charts. This is what it means. It went off the charts. So what you thought was effectively um uh uh uh um a very uh well-diversified uh portfolio uh with low risk ended up falling in this risk of false diversification and hidden leverage. That's in a way what's happening with the 6040 potentially, where you're in that quadrant two, where volatility increases, fixed income comes to the rescue. What happens when correlations break, and what happens as this crisis mechanically uh take us to that level? And these are things like the VIX kicking in and inflation, whatever. The challenge with high inflation, and the reason I agree with you, is that high inflation is is the path for lower fixed income and lower equities potentially. Okay, and and that exposes that correlation risk, increases you know, uh volatility, et cetera, et cetera. And and in some ways, you know, this this nightmare of the tariffs has been, again, we we keep it evergreen, but it's it's the idea is that it's a path, you know, where you're effectively increasing um inflation, volatility, uncertainty, uh destroying value. And that's why I think uh at first instance was so negative, and you have, in the case of the US, this this trifecta of lower US fixed income, lower uh US equity, and lower dollar, which is just an emerging market behavior. You don't see that. Uh even during Brexit, uh you had uh sterling collapsing but UK assets going up, you know, because of a total return gain. So I think in that sense, it's very important to understand that you want your defenders to be volatile. You need them to be volatile, so do not confuse volatility and risk. But the problem is the unreliability of correlation. If you knew uh that your defender is going to be reliable during the crisis, then you want it to be as volatile as possible. The problem is that reliability, and that reliability is largely a function sometimes of positioning. I'm laughing.

SPEAKER_01 32:13

I'm la I'm laughing because um I love your analogies with um uh goalkeepers defenders, but I was thinking what if your goalkeeper is uh René Higuita, the Colombian uh goalkeeper, you know.

SPEAKER_04 32:26

The scorpion. Yeah, the scorpion keeper. I would have a heart attack. If I if I've been Colombian and he did that, I I would have a you know I I I was probably 10 years old at the time, but I would have still had a heart attack.

SPEAKER_01 32:38

That was for for for listeners and viewers, that that's uh 30 years old, by the way. That was uh England versus Colombia. You can check it on YouTube and the ball comes in and Higita just does this scorpion kick and it's hilarious, like yeah, brilliant. But but uh or closer to home, Bruce Gravlar is another one. We could what if your goalkeepers are are a bit more volatile, you know?

SPEAKER_04 33:01

Look, and I think that that's why I I make the difference between defenders and goalkeepers. I I don't think fixed income is a is a goalkeeper. I've always viewed fixed income as a defender. And the problem is, you know, back back in the day uh when when I think it's in the book, I I talked about uh de Bund being, I called it Franz de Bund Beckenbauer, with again, uh it shows my my age, but it was this legendary defender from Germany, right? Uh uh who who passed away now, but incredible defender. Uh so de Bund may have been an incredible defender once upon a time, but you know, uh in his mid-70s uh with negative nominal yields, it was very obvious he was not going to be able to defend. Um so I think in in in that sense, part of what we do and what we're trying to do is, okay, in a world where conventional defenders like US Treasuries and the dollar are no longer as reliable, what sources of reliable, reactive convexity, you know, are there that can protect us with the lowest cost and carry? And that's what I devote my professional uh career to. And uh similar to football, it's it's a tough game, right? I mean, you could be a uh striker and miss 20 and do one and you're the hero. Goalkeeping is is tough. And and uh but I think where my research and my work and our strategies have taken us is one level further, which is it's not about just protecting the mark-to-market of the portfolio. You know, when we you you don't buy, you don't have a goalkeeper just because you're scared that the other team will will uh will shoot, you know. You actually can counterattack, you can you can be uh you know, it's it's a critical part of of the team. And so the whole idea of rebalancing alpha as as teamwork uh builds on the idea of anti-bubble and builds on the idea that you know in March 2020, right, when let's say equities are down 20% and your protection is up 20% for the sake of argument, you would be very happy because you say, oh my God, my $100 is still $100, right? So uh I avoided this big drawdown and thanks God I have this thing. Now, what happens with a lot of people is we are like uh deers on the uh on the headlight, right? You're like completely frozen, the crisis is there, you're like, oh my god, if I monetize my protection, I'm gonna be unprotected. And what if the market goes down another 20 or 40 or 60, which is how it feels at that time? And so most of most humans will naturally be frozen and just cross their fingers and say, and and and and a month later or six months or whatever, the equities recover and your protection disappears. And so you ended up with a nice mark-to-market hedge. But you didn't really take the opportunity, which was let's monetize the 20 and use those $20 to buy equities are 80, which buy me roughly 25 units. So by the time I uh market goes back to part, I've I'm no longer back to 100, I'm at to 125. And that nonlinearity of uh portfolio construction, that embracing the volatility of the markets in a way that we do it in uh the most unemotional way possible. And to do that, you need convexity because you need a way where your protection, you know, if you take those profits, you know that as the market goes down, you keep generating that protection. That convexity is so important and effectively results in this rebalancing uh alpha. And that non-linearity of portfolio construction is not well enough understood and is a the kind of the work that I've done with the with the white paper.

SPEAKER_03 37:08

And and and I think it's an area that deserves, it's probably one of the most misunderstood areas of of finance where everybody understands the concept of rebalancing. Uh, but most people see it as, oh my God, if I don't rebalance, then within five years I'm gonna be just equities and I lost my diversification. It's almost like I mean, by choice, when you actually understand the power of rebalancing and you think about rebalancing as as a as a line item in your portfolio, it it changes your perspective.

SPEAKER_01 37:37

So that wraps up part two of Diego Perea's interview, and part three will be coming up shortly. So it's clear that Diego is a fan of Nassim Nicholas Taleb's book The Black Swan, Fooled by Randomness, and he opened up the discussion focusing in on the ludic fallacy whereby even our most sophisticated mathematical models are unable to model accurately the world we live in because it's just so unpredictable, it's full of randomness. If we assume then, therefore, that the world is nonlinear, uh we may also assume that what worked in the past may not work in the future. And this opened up his review of the 60-40 portfolio, 60% stocks, 40% bonds, and perhaps that 60-40 portfolio is not gonna do the job for the next 40 years. Perhaps the 60% will, but you gotta be perhaps a bit more creative and curious with your 60% weight integrities, do the valuation work. But perhaps the 40% that there's other options is not strictly restricted to fixed income. Near the tail end of the interview, Diego started using some of his famous sporting analogies, and we had a bit of a laugh. Uh, I mentioned Rennie Higuita, people of a certain age will remember uh that crazy Colombian goalkeeper. Uh during English England match, I think it was 95. He uh made a save by using a scorpion kick. Well worth uh YouTube watch on that. But the bigger point was that you know you can have goalkeepers, but goalkeepers may be volatile, they may be great goalkeepers, but they can be volatile, just like some defenders can be great defenders, but they can be volatile. So coming shortly is the final uh part of Diego Peria's interview, part three. Stay tuned for that. Hope you're finding all this very useful, and I hope that you can use it uh in some of your own asset allocation. Thanks for watching, listening, take care.