Animal Spirits Podcast - Talk Your Book: The Fabric of Risk

Episode Date: September 20, 2021

On today's Talk Your Book we spoke with Rick Bookstaber of Fabric Risk about how advisors and their clients should approach the concept of risk in their financial plans. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Fabric Risk. Go to FabricRisk.com to join the waitlist to gain early access. So if you're a financial advisor, check it out and your email. That's FabricRisk.com and you can learn how to help your clients better understand the risk in their financial plan. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Batnik and Ben Carlson work for Ritt Holt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management.

This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ritt Holt's wealth management may maintain positions in the securities discussed in this podcast. On today's show, we speak with Rick Bookstabber from Fabric. And Rick is probably not a name you've ever heard of. but very important in the industry. I should say he's held a lot of very prominent positions. For example, Rick was Morgan Stanley's first risk manager.

Some of this is from Wikipedia. He moved to Solomon Brothers and was in charge of firm-wide risk. He had similar roles at Moore Capital, let's lose Bacon Moore and Bridgewater. He then was at the Treasury Department's Office of Financial Research. In 2015, Rick became the first chief. risk officer at the University of California, where he helped oversee the university's pension and the diamond portfolios, just $110 billion worth of assets. So needless to say, Rick has spent his entire career thinking about risk, actually managing risk. And now in his

latest venture, he founded a company called Fabric that is trying to bring institutional level risk management to financial advisors. I feel like if you have your own Wikipedia page, you're a big deal. You made it. Yes. Do we have one? Does Animal Spirits have one? I'm pretty sure we don't. Probably not. If someone knows how to do that, make it for us and then just write a bunch of fake stuff in there. That'd be amazing. I would love that. I went to Princeton. I graduate in three years. I don't know if anybody knows that. I can just say like Michael's bio. He has a big TV with a line through it. Anyway, this was a very interesting talk because I came from the world of institutional investment management and quantitative risk models in that space, that's a huge deal.

The measurement of risk for them is a big deal. And it was interesting to hear Rick talk about taking that mindset and then shifting it to working with RIAs and financial advisors and their clients because it's a totally different mentality. And me going from the institutional world to the individual, more family approach individuals, it was great for me because I think that that space has a much more realistic and common sense approach to risk. Not everything has to be a sharp ratio or a sortino ratio or some mathematical formula for it to make sense. It doesn't have to be measured exactly down to the third decimal place. It can be as simple as here are our financial goals. Let's figure out how little risk we need to take to get to those financial goals. How well

on track are we two reaching those? That's something that you don't get a lot of the institutional world. favorite quotes about risk, because you're right, people spend a lot of time trying to quantify it. And there's a huge element of that, obviously. But I prefer the more abstract thoughts thinking about risk. So an example of that is from Elroy Dimson, who said, risk means more things can happen than will happen. I love that one. Another one is from Carl Richards, which goes like this. Risk is what's left when you think you've thought of everything. I can't tell anymore if sometimes Buffett is in the Mark Twain. Albert Einstein thing where some quotes are just attributed to him. But I think one of them was like

risk comes from not knowing what you're doing. That's a good one. Not understanding what's in your portfolio. Yeah, there's a lot of good ones like that. But it's funny. People fight over risk. Like, these are all right. None of these like, nope, that's not what risk is. No, no, no, no, risk is this. It's a concept. It's a concept that has a lot of different definitions depending on where you are. Because like risk means a hugely different thing to some, a family with $25 million versus who's going to be set for life and for generations maybe versus someone who's got a few $200,000 and trying to make it last to retirement. There's a huge difference there in the definition of risk and what it means to them. So, all right, without any further ado, here is our

conversation with Rick Bookstaber from Fabric. We are sitting here today with Rick Bookstabber, founder and head of risk at Fabric Risk. Rick, I've spent my career working with institutions. They spend a lot of time and energy and resources on tracking risk for portfolios. It sounds like You've had a similar route where you've worked in portfolio managers and institutions. What has your path been with risk and how did it lead you to founding fabric? Well, I started out on the institutional side. I started in risk management when risk management was just beginning. I was in charge of risk management at Morgan Stanley and then at Solomon Brothers.

And after Solomon became Part City Group, I moved into the hedge fund area. So I did risk management more capital with Lewis Bacon and then at Bridgewater. but the time that I moved away from that part of the world into advisory or the basic space of what you might call asset owners was when I worked in Treasury. I went to Treasury after the financial crisis. They asked me to help with some of the reformulation of the financial system from a risk standpoint. And the thing that was obvious when I was at Treasury is that the real difficulty. The people who were hurt the most from what happened in 2008 were individuals. And yet individuals didn't really have any sort of ability to do risk management, to evaluate

the risks in the face of crises. And so from that point, I started to direct myself more towards the asset owner world. And my first stop was University of California, where I was the chief risk officer for their pension and their endowment. What's interesting is University California has a pension that's about $170 billion. It's really kind of surprising. And so I went from there into developing fabric where I really redirected myself from the pension world into the wealth management community. So that's kind of a long circuitous route, but that's how I ended up working where

I am now. We're going to get all into risk today and how different people think about it. But I would love to hear what does chief risk officer or what is risk management at such a high level? If you're a risk manager for Morgan Stanley, like practically, what does that really even mean for our listeners who might not understand how that works? Risk management differs in its function depending on the type of organization you're in. If you're working for a bank or a broker dealer, which Morgan Stanley is and Solomon was,

it's what would be called a control function. You're trying to make sure that the traders have very strong incentives to take as much risk as they can are under control. As you go to a hedge fund, of course, the main person who understands the risk in the hedge fund is the principal who owns the firm. So there you're working more as a partner to try to make sure everybody understands where the risk is and you can kind of navigate around the shoals of uncertainties in the market. And then as you move more into the realm of the advisor or the pension fund, you really are kind of following in more with that as a function. It's more a partnership function. The big difference is you're concerned about long-term goals as opposed to what will my return be next month. I kind of saw a similar thing when going from working with institutions to

more individuals where it goes from more quantitative to more qualitative. So how do you view view risk in terms of, because there's both, right? There's certain things that you can quantify and there's certain things that are just unquantifiable. So how do you view that concept? Well, when you're talking about advisors to clients, the key is it's an issue of helping them make sure they can reach their goals. And there's a lot that's qualitative in doing that. Of course, the markets have quantitative characteristics and risk of markets have quantitative characteristics. But that's just half the equation. The other half the equation is a human one. And you can't quantify that. So it's a softer approach to risk management than what you would be doing

if you're dealing with an institution, whether it's a by-side or a sell-side institution. So people talk about risk through the lens of risk can mean financial ruin. Some people equate risk with volatility. Financial advisors often equate risk with neither of those things. The real risk is not being able to achieve your financial goals. Looking at this through, and we're going to get into all about the product and the services. But just you personally, when you think about, I guess, stock market risk, that's, I think the thing that comes to mind for me, at least. Do you think about the VIX? Do you think about DRADA? What do you think about, Rick? In the broadest sense, there's a yin and a yang. The yin is returns. It's the right side of the distribution, trying to

beat expectations. And the yang is the left side of the return. And what can happen that can be adverse. A few years ago, when I was at University of California, our annual report was kind of cleverly designed. If you open the report on one side, the cover said opportunity. And if you took the report and turned it around and upside down, the other side, as you open it up, said risk. I think that was the best manifestation of the point that you have opportunity on one hand to try to meet or exceed your goals. You turn things around and you have risk and uncertainty, on the other hand, which is the risk that you will largely underperform your goals. So risk and opportunity are really sort of two sides of the same coin. But in terms of

the risk that I really think is where you need to focus, it's not the day-to-day ups and downs. We all know that the market goes up, it goes down, it moves around day-to-day, it's the material deviations from expectations, the sorts of things that happened in 2000 or 2008 or what we may be set up for today in the nature of market, things that can matter to an individual who has time frames measured out in years. One of the interesting observations over the last decade is a lot of people have been so hyper-focused on risk management. And by definition, risk is always present, even if we don't always feel it, even if it

always doesn't manifest it. So I'll show its face. Risk is always there. But in a long bull market, which is what we've been in, risk management looks foolish. you have to strike the balance of being mindful of risks, but not going over the ledge. So how does Fabric fit into this equation? Your point is really a good one. I've lived with that point through my career in risk management.

I mentioned I've been in it since the early 1990s. You're wrong most of the time. You worry about a risk, and most of the time it doesn't occur. People have to realize that if you're a trader, you better be right, or if you're an investment manager, you better be right over 50% of the time. If I'm right 10% or 20% of the time where I'm concerned about material risks, that's a pretty bad world. So the key approach to looking at risk is, first of all, to understand, number one, that

you do want to look at material risks and not try to worry about the day to day. Number two, that you're worrying and concerned about things that more often not are not going to occur in a timeframe where you're talking about them. But I do have the advantage of I'm not trying to be a hedge fund manager. So it's okay if people are constantly looking and saying, come on, Rick. We've been saying this for like two years. But you have to be aware of the sorts of scenarios that might occur. And then you can monitor the market to see if things are moving in the direction where that becomes more and more of an issue and be kind of forewarned so that if something does occur, it doesn't hit you totally by surprise.

in the military people train over and over and over again so that in the real event, they say, gee, this was just like training. This is not a big deal, even though bullets are flying. What you wanted to do as an advisor to your client is in a way, train them in the possible events that can occur so that should one occur, they sort of say, I get it, I already have been there to talk about it, I know what to do. There's a lot of different ways that I view risk management. You could view risk management from the perspective of we're going to try to

hedged out certain risks in our portfolio. It could be risk measurement where you're trying to figure out which spots of the portfolio could see volatility or pain if certain things go wrong. And then you have risks in the macroeconomy or whatever the investment markets if things move a certain direction. So are you trying to help advisors understand where the risks line their portfolio? Are you helping them set expectations with their clients? Are you helping provide a range of possible outcomes all of the above? How does you're thinking of risk management help advisors try to spot where their portfolios might have some damage potentially? It's really all of the above because all of those impinge on risk management,

but the final place you want to rest is on the portfolio. And you're not only want to rest on the portfolio as it stands right now, but understand how that portfolio and asset allocation might have to change over the course of time. But to get there, you want to look and understand what possible events could occur in the market. If those events occur, how does that make? manifest through different components of the market, what we would call risk factors, and then how do those translate into the realities of the portfolio that's being held? So at the end of the day, it's really quite simple because it's the advisor looking at the client's portfolio, understanding

what types of events could impinge on that portfolio in adverse ways, and then understanding what that means for the client. And also, if one of those events does occur, let the client know ahead of time, what may occur so that they can react to it in a reasoned way. You want to do a premortem and lay out all the possible risks. So if you don't mind just sharing a little bit about fabric and how you plan to work with advisors, I know it's a new company, but what's the vision for this? What we're doing is we've basically created a risk platform that specifically addresses the way that advisors can work with their clients in relation to two types of risk.

One is behavioral risk, which can be what I was talking about, making the rolling decisions, given the nature of the market, the nature of what might evolve or occur in the market, and the other is market or asset allocation risk, trying to understand if the current allocation is correct or incorrect for the client. There's a lot going on under the covers to do that, but we've worked really hard to create a user experience that's intuitive and that's elegant for the client and advisor so that you can know what matters, understand not just the best way to get to your goals. That's not quite the way to put it, but understand the type of events that can occur, the type of risks that are sitting between

you and your goals, and look at it through various lenses. One that we use, we have a partnership with MSCI, which is a company that's mostly services institutions and has risk factor models. And we use those risk factor models as the basis for understanding portfolios so that people can see in their portfolio, do they have an unexpected amount of exposure to technology, which most people actually do right now, to China? Guilty. To momentum. And if they do, what can they do to reduce that? To get a portfolio that makes more sense for what they're trying to do for their clients. Your point about getting the right asset allocation for someone, which is not always necessarily the best one, is a good one. Because the way I've always looked at it is you have like

this willingness, need, and ability to take risk. And those three don't always. always line up perfectly with one another. And I think another problem for a lot of people is that your perception of risk changes over time. So if you have more money, I feel like those drawdowns can hurt more because you see more fall in a dollar amount, even if it's the same percentage. Or you have a life event. I noticed that my relationship with the risk has changed now that I have a family and I have

three kids and I'm thinking about them. So I'm curious, how is your relationship with risk changed and evolved over time? And how is it factored into how you have decided to sort of build this for other people? So it's interesting because the financial advisor client relationship is way different than anything that exists in the institutional world. And because of that, the mode of risk management has to be a lot different. The way it's different is if you're a banker, broker-broker dealer, you care about risk over the next few days.

You care about what might happen before you can get rid of your inventory. If you're a hedge fund manager, you care about risk over the next month or two because you report your clients every month or two and you can. can always liquidate over a period, unless you're very big, over a period of weeks. So you're focused on returns, and you don't have to worry about the dynamics of what happens in the market. If you're an advisor, you have more dimensions to think about because of what I mentioned before. You don't only have the market, and you're not only looking at returns, you're looking at a client on the other side. So it's a little bit like it's a knife versus a scissor. If you're

an institution like a broker dealer or an asset manager, all you need is a knife because you're just cutting as far as returns go. If you're in asset management, the risk is a scissor because it's how the client interacts with the portfolio. And there's, of course, interactions between the two so that if the portfolio goes down, it changes, as you're mentioning, the nature of the risk tolerance and risk capacity of the individual. So you can't look at either one in isolation. And you also, it's not a set it or forget it exercise. You can't just look at here's my portfolio now. Here's the risk tolerance right now. Here's the capacity. Okay, I'm done. You basically have to move along. It's a little bit like with a guided missile. You want to have the ability to do

mid-course corrections because you know things will change, not just in the market, but with the nature of the client. That makes it a much more complicated exercise than what's done typically. And if you try to take the risk management approaches or systems are used in an industrial setting and an institutional setting. People may say, wow, you know, those are so complicated and complex. Let's put it over for advisors. It's not going to work because the problem is different. It's a different problem than what you have with most institutions. It seems like market cycles are happening much quicker these days. Obviously, 2020 was hopefully the anomaly of all anomalies with the Fed stepping in, but they're clearly a bigger player in the

field now than they used to be. And just the whole nature of markets. And it was before 2020, we saw V bottoms come back to, I remember the Ebola virus scare. I think that was 2014 was one of the first times I remember seeing that V bottom. We've had half a dozen of them over the last 10 years. How might fast moving markets change how we need to think about some sort of typical risk management strategies? If you are, an individual has a long time frame, you don't really have to care about week to week. You have to care about risk that are really material. So you can leave a lot of what you see to have the asset managers and the hedge funds deal with. As far as you're concerned, it's noise that'll dissipate out. What really matters is not the very quick back and forth

of the market because of the news cycle and the speed with which information comes in. It's the big risks. Right now we're looking at inflation as a problem. A tech bubble is a problem. anything from fed tapering to COVID next wave recession. These are things that really can affect you, even if you have a time frame of 10, 15, or 20 years. Because you can have, and it's been the case in the past, 2000, when we had the dot-com bubble, we didn't get back to where we started with that move up again until 2013.

That was 13 years. And so we think about the lost decade with Japan. well, that was a lost decade. And there were others, 1960 to 1983, flat market over that whole period. And if the market's flat, it's really down because you have an assumption, some actuarial assumption of maybe 7% return on the market. So over 13 years, if the market is flat, it's really like you're down 15% or down more like 30, 40% from where you should have been. So it's important to focus on what matters and what's material. and not get kind of sidetracked by the up and down gyrations, unfortunately, it's not like

there's a million things to worry about when you talk about material risk. So it's not hopeless to be focused on them. What do you think are some, if a advisor comes to you, and I guess I'm curious how this works, whether they just kind of share their portfolio or their models or their strategies or what, but what do you think are some avoidable or unnecessary risk that advisors can take their client portfolies? Is it as simple as not being diversified enough and having too much concentration? Like, what are some other just simple avoidable risks that people can just avoid mistakes to take some of those off the table? Basically, any risk that can't generate expected returns if you take it is one you want to get rid of and one that should be diversifiable.

So if you basically have risk in your portfolio that is just there and doesn't have the basis of generating expect return, brand at a plus or minus over it, it should be something you can get rid of to a large extent. And the main tool for doing that kind of risk management one and one is diversification. The problem is some people think they're diversified and they really aren't, or more to the point, people are diversified and people can be diversified most of the time, but not when it really matters. When you have a major dislocation in the market, all assets kind of move together, correlations move towards one. And you can't diversify when all of your assets are moving together. To diversify, you have to have things, some things move up while

other things move down. So people can get into a false sense of security saying, I'm really well diversified. And that's fine until a major problem occurs and then you discover, no, and it doesn't matter what I was holding them down 30%. One thing that we do that helps to understand where you might not be diversified, where you might have exposure without realizing is what I was about the factor-based approach, which is kind of a standard way of looking at risk within institutions. And the factors are things like I was mentioning. It could be, are you really exposed to momentum stocks? Are you really exposed unduly to value stocks? Are you too exposed to technology? Right now, because so many indexes and ETFs or market cap weighted, if you are

passive in a standard index like the S&P 500, you actually have very high factor exposure to technology. The top 10 stocks in the S&P are 25% of the weight, and that's mostly technology plus Amazon. So if you break things apart, not look stock by stock, but look factor by factory. You can see where you think you might be diversified, but you actually aren't. China's another example. You may have zero China exposure in the portfolio if you look stock by stock. But you have supply chain exposure to China in a lot of positions. And then that means on a factor basis, if something happens in China, you'll discover it has an effect on your portfolio. Can we talk about some of the common risk mitigation strategies could be something

as simple as just a 50-50 portfolio, stocks and bonds, Harry Markowitz, the father of all of this. That's what he did, called it a day. And then there are some more exotic strategies. One thing that seems to be everybody's favorite after the fact are tail risk strategies. And those are designed to not only be non-correlated, but to be negatively correlated to the rest of your portfolio when you really need it to be. Can you talk about those strategies in particular? And do you have any thoughts on them? I don't like the term tail risk. I understand that people use it because it's the extremes of the distribution. But tail risk is really material risk. It's risks that when they happen, it's really, really bad. And those sorts of risks actually happen a lot. If you go back over time in any

given decade, you're going to have multiple tail risk events. So I don't consider those tail events. I don't consider them things to be managed in a special way. That's risk. That's really where you have to focus if you're doing risk management. And so really what people think of as tail risk is really inherently part of the market. And it's the part of the market that is where the, I hate to say the richness of risk is, but it's where the bulk of risk you have to worry about is. And having said that, I don't think there's a magic bullet, especially if you can't go short. If you can short positions, one way to deal with tail risk is to just short the market. Another way to deal with tail risk would be to do put options, but those actually tend not to be

a very useful tool because they're fairly priced. They basically tend to be priced to that if you use them on average, your expect return is not going to be a lot different than if you just absorb these events as the approach. The best thing to do is to have your asset allocation reflect the reality that these events can occur and that if some of these events occur that are very bad, it can drag you along for multiple years for even a decade. And so move from being aggressively into equities to being 50-50 equity bonds to being having a beta or an equity exposure of 0.3 or 0.4 as your goal horizon shortens. What I hear from you is when you think about risk management, you think about that

at the portfolio level, not in the sense that, oh, be careful, stocks are expensive and I can predict a crash is coming. Is that right? That's right. I don't want to try to say, oh, there's going to be a crash. What I would say instead is the market is vulnerable. So something may occur or not. Well, here's the way you think of it is.

Rick, that's risk. You're doing a podcast and your dog store's barking because the front doorbell rang. So what you have to do is realize that risk really comes from two things acting in unison. One is the market's really vulnerable. The other thing is an event occurs that tests that vulnerability. You have a catalyst, some event, and the market is set up so that when that catalyst hits, the domino's ready to fall. Right now, I think.

we have high vulnerability. But do we have an event? Will an event occur that tests that vulnerability? That's the other part of the equation. And so I can say something about the first of those. I can't very well predict when or if the testing event will occur and how severe it'll be. What is your feeling with scenario analysis and all this? Because back at one of my old institutional places I used to work at, we had these scenario stress tests where it would say if rates go from 2% to 4%, here's what will happen. If oil goes from 75 to 150, here's what will happen. All these different events where if you move certain pieces, here's what will happen. And I always found it hard to rely on those because a lot of times the reaction to the news is

different than the news itself. So if you think inflation went from 2% to 6% or whatever and the tenure treasury didn't budge or if anything, it fell. So how do you think about those and how could those potentially be helpful when sending expectations? When are they not helpful? I've mentioned scenarios. That's kind of the core of what we do. And I think it's the core of the risk that you need to deal with. It's the scenario is the event times vulnerability. That's what it is. And I think scenarios are done in a very simple way, but wrong way right now. What people do to say, oh, in this scenario, boom, equities will be down 20%. You see a bar chart.

The bar chart shows equities down 20%, bonds down 10%, and so on. That's missing three key components of the picture of scenarios. First of all, equities won't be down 20%. Maybe it'll be down 50, maybe it'll be down 30. There's this cloud around what could happen. And where you end up in that cloud depends on how severe the scenario is and how the market is currently set up to absorb that scenario. The second thing is, it's not like, boom, the market's down 20%.

Okay, we're done. Any material risk as it manifests itself in the market moves over time. It takes time to go down, takes time to recover. As it's going down, it's contagion, it propagates to other markets. It's just not that simple. And the other thing is, it's not like equities go down. different components of the market will go down different amounts depending on what's going on, and this again gets to our approach of using factors.

For example, with inflation, in an inflation scenario, it's not like, boom, we have inflation, now the market's down 20%. It'll work its way through. We'll learn more and more about it, and the market will react and so on. But it's not as if, oh, the S&P's down 20%. Companies that are very exposed to short-term borrowing are going to be hurt more than other companies because rates will go up. Companies that are small relative to larger are going to be hurt more because they can't pass through their costs as costs go up. I'd rather be Walmart than

the people who sell them the rakes and shovels that they then sell. So low cap will be hurt more than high cap. Brick and more companies will be hurt more than companies that just have intellectual property. So the point is you have to look over time. You have to understand. You have to understand. there's this cloud of uncertainty around the scenario, and you have to break out what can happen based on the scenario in kind of a factor approach, because different components of the market will be affected differently. So it's kind of messy. It's not like, okay, I can put this on the bar chart and I'm done, and it's not just numbers. It's a narrative. There's things to talk about to understand the process. So, Rick, we have a fair amount of financial advisors who listen to this podcast. Let's

say they listen to this and they hear you and they think, okay, I obviously don't have as well the handle on this risk concept as I thought I did. What happens next? How do they get in touch? How do they come to you and how do they potentially understand more about what fabric can do for them? The best thing to do is if you go to our website, which is fabric risk.com, we have an application that will deal with a lot of these issues that takes the factor approach and that helps you understand how you might reach your goal or miss your goal based on different things that can happen in the market. Right now you can sign up for a demo for it. The product itself is actually it's kind of good timing. It's going to be coming out in the next week or two. We've been developing

over a long period of time. So then you can get a sense where I'm talking about. And I think the thing that's important is that what I'm talking about sounds complex and there's a lot of moving pieces sort of under the covers. But ultimately, what it boils down to is understanding taking your portfolio and seeing how under different scenarios, your portfolio might behave. So you really finally are just looking at the portfolio and getting a context for it. You don't have to worry about all of these moving parts that are going on behind the scenes. But the key point is that there's sort of three points, I think. One is you can't just look at history to understand risk today.

You have to know the nature of the market currently. Risk isn't just a number. It's a narrative, it's a process, it's a dynamic. And if you want to understand risk, the best way to understand them is through the factors that drive your portfolio and that you and your client sort of intuitively understand. I think everything that I'm saying, an advisor intuitively understands and a client intuitively understands because they have experience, they sort of see the markets, they kind of know how different parts of the markets are affected.

So that's sort of the core of what we're trying to do and put it. in a form where people can integrate this stuff with their clients really effectively. Well, Rick, this is terrific. Thank you so much for coming on and sharing your story with us. We appreciate it. Thanks for having me on. All right. Thanks again to Rick.

Remember, go to FabricRisk.com to learn more, especially if you're an advisor. Send us an email, Animal Spearspot at gmail.com. Thank you.