Is Warren Buffett blind to tail risks/risks of ruin?

Discussion in 'Risk Management' started by Daal, Feb 1, 2017.

  1. Daal

    Daal

    Back in 2008, Buffett said he was buying US stocks with his non-Berkshire money, with up to 100% of networth

    http://www.nytimes.com/2008/10/17/opinion/17buffett.html

    "So ... I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worthwill soon be 100 percent in United States equities."

    If you are really rich, it makes all the sense in the world to have some money stashed away just in case there is some kind of black swan/tail event and you lose it all (or most of it).
    That's what I think he was doing by having some US bonds outside Berkshire.

    What is not consistent with that is to have evidence that the black swan is showing up (2008 crisis), then take the money that you had stashed away (that would guarantee you would be wealthy no matter what happened) then put it in something highly correlated to what your main assets are in. Essentially, Buffett shorted even more puts on the 'America always comes back' thesis , and he put even his safe cash in there. It gets worse when you consider that Berkishire is leveraged 1.2-1 or more. He is basically saying that the utility of money doesn't matter to him, risk of ruin doesn't matter to him, all that he cares about are benefits (better valuations/higher expected returns)

    But as Taleb shows here, you can add benefits all day long, when risk of ruin/downside risks are involved it doesn't matter how much you add benefits, its the negative side of the tail that matters



    This is also confimed by the Kelly formula that shows that you can keep adding benefits (bigger and bigger pay offs) but with uncertain win %'s (that is, with realistic win percentages), the recommended bet amount won't go up that much. At some level it just sorta stagnates. A 6-1 payoff bet with 50% win percetage leads to 41% bet, a 99-1 payoff with the same win pct leads to a 49% bet. Benefits don't change the math much

    Is Buffett just tail risk blind?
     
    Last edited: Feb 1, 2017
  2. JackRab

    JackRab

    I think what Taleb means, is that risk of ruin protection will always keep it's value... no matter what the benefits. So basically he says, the ruin-put (delta 3?) will be 1 cent no matter the benefits.

    But what if we would look at a put that's not that far out... more like a delta 10 or 15. That will change when benefits are added I would think.

    My 2 cents re Buffet... his idea is, what comes down must go up, especially if it's a good blue chip.

    If the world goes to ruin... it doesn't matter what you hold, everything goes to shit. The puts that you would hold... 'poof'... gone, because your broker/bank would be bankrupt and derivatives are not covered in any insurance. That insurance company would be bust as well... so SIPC etc doesn't matter anymore either. Money doesn't exist anymore, so treasuries etc worthless...

    So in a ruin situation, when you're diversified... you would lose anyway. So what's the point of protection?

    In 2008 we were in the middle of a tail event. You don't exactly know when it stops, but it would stop at one point and then there will be recovery. Unless everything goes to shit. But again, nothing has value then.
    If you are not leveraged to the hills and don't need the money in the near term, you will always survive a tail event with a diversified portfolio.
     
    vanzandt likes this.
  3. Maverick74

    Maverick74

    There was "chatter" in 2008 that Buffet WAS on the verge of ruin. He sold billions in naked puts on the SPX and rumor was he was days away from a margin call. The trade was held by Goldman and Goldman themselves were days away from being insolvent. Apparently, if you choose to believe the story, some powerful people stepped in to save Goldman and Goldman in turn did not liquidate Buffet. How much of this was true? Who knows. But it was widely reported even on CNBC, who usually keeps his genitals in their proverbial mouth. I think it's safe to say that the rich and powerful get certain benefits that your average ETer doesn't get.
     
    themickey, speedo and vanzandt like this.
  4. JackRab

    JackRab

    Yeah I remember those stories about the short puts.

    He was basically selling fire insurance on a burning house... or maybe it was fire insurance on the whole country on fire...

    Curious to know if it were short term puts or longer term.
     
  5. Maverick74

    Maverick74

    Long term. I believe they were to expire in 2019 or something like that. It was NOT an exchange trade but OTC and the agreement was that they could not force him to cover as it was a swap trade. However, the bank itself almost went under which is what made this thing interesting.
     
  6. Maverick74

    Maverick74

  7. Maverick74

    Maverick74

    And another....

    ftalphaville.ft.com/files/2014/01/Buffett-Puts-Jan-2014-2.pdf
     
  8. JackRab

    JackRab

    Thanks @Maverick74.

    What would've been the IV for 10 year options around that time, you think?
    Wouldn't be too high... 18-20? Those IV's wouldn't have moved that much during GFC...

    So he sold 5 bln worth of puts... say ATM...
    10 years at IV 18. Aggregate dividends would've outweighed the interest, so the real ATM would've been what, 10-15% lower than spot index?

    Se he could lose maximum 3x or 4x premium I think...

    (PS, still reading the .pdf)
     
  9. newwurldmn

    newwurldmn

    I remember that as well. Goldman credit rating was getting hurt because it had like 10bn exposure to buffet and buffet credit was downgraded because of the puts and their purchase of the railroad. They ended up rolling the puts down and out.

    Jackrab: the implieds on those trades were very high. Variance out that far was trading at like 30-35. There was a dislocation in the market because insurance companies started buying long dated vol to hedge their variable annuity exposure. No other participant could weather the marked to market so Berkshire cleaned up as the only seller of vol.

    My guess the reason they traded it as puts was to keep the position vanilla for publicity purposes.

    Clearly the trade didn't work out but it was actually a very shrewdly thought out position.
     
  10. Daal

    Daal

    The US could have imploded but the rest of the world didn't had to (at least, not to the same extent). If you look at in the 30's, lots of countries had GDP collapses much smaller than the US. Switzerland/Luxemburg and other places would likely still to be safe havens, he could have taken his safe cash and put in those places ("just in case"). That would be buying ruin protection. He could have just doubled down with his Berkshire assets, but no, he took it all 100% of everything and put it all on the same thing on the belief that the US always comes back. At 78 years of age. Just seems a little nuts to me
     
    Last edited: Feb 2, 2017
    #10     Feb 2, 2017