Position Sizing When Markets Break feat. Rob Carver | Systematic Investor | Ep.386

Episode Overview

• Explores the "Total Portfolio Approach" to investing, using the metaphor of a "total work of art" (Gesamtkunstwerk) to explain why positions must be viewed as an interconnected system rather than isolated bets.
• Examines critical risk management techniques, specifically how systematic traders adjust position sizes based on volatility and the dangers of conflating high trading volume with actual liquidity during crises.
• Discusses the practical construction of a robust portfolio, including the classification of markets (Traditional vs. Alternative), the mathematics of correlation, and the limitations of "AI" in finance.
• Contrasts the emotional pitfalls of discretionary trading against the rules-based discipline of systematic trend following, using recent market events like the volatility in Silver as case studies.
• Provides a deep dive into "Crisis Alpha" and why mathematically optimized portfolios often fail in real-world liquidity crunches compared to cash-efficient traditional markets.

Key Concepts

• Gesamtkunstwerk (The Total Portfolio Approach): Investment decisions should not be made in isolation. Like an opera where every element contributes to the whole performance, a portfolio is a cohesive system where every asset interacts with others. Success comes from managing the aggregate risk and correlation of the entire system, not just picking individual winners.

• Volatility Adjusting Positions: This is a vital risk management mechanism where position sizes are reduced as an asset's price becomes more volatile (often during rapid run-ups). This forces the trader to systematically "take profits" during parabolic moves. When the inevitable crash occurs ("Freaky Friday"), the trader holds a smaller position, significantly mitigating losses compared to buy-and-hold investors.

• The Illusion of Liquidity: Investors often mistake high trading volume for liquidity. In normal markets, assets like Silver or Natural Gas seem easy to trade. However, in a crisis, liquidity evaporates instantly ("one door out of the cinema"). The lack of buyers causes price gaps and slippage, meaning stop-losses cannot be executed at desired levels.

• Systematic vs. Discretionary Psychology: Discretionary traders often fall for narratives ("this time is different"), leading to emotional over-leverage and ruin. Systematic strategies rely on cold rules—combining trend strength with volatility targeting—to remove emotion, preventing the urge to double down on winning trades that are becoming risky.

• Market Classification (Traditional vs. Esoteric): Markets should be categorized by return drivers. "Traditional" markets (S&P 500, Treasuries) are driven by broad global sentiment (Risk On/Risk Off). "Alternative/Esoteric" markets (electricity, exotic swaps) are driven by idiosyncratic factors specific to that commodity. While esoteric markets offer better diversification, they often lack liquidity.

• The Crisis Alpha Paradox: While mathematical optimization suggests filling a portfolio with uncorrelated "Esoteric" markets, this fails during a crash. Traditional futures markets provide high leverage with low margin requirements (cash efficiency). To survive a liquidity crisis, a portfolio needs significant allocation to these liquid, traditional markets to monetize short positions when cash is needed most.

• Dynamic Correlation Estimation: Investors often underestimate the benefits of trend following because they assume high, fixed correlations (e.g., 0.7) between assets. In reality, correlations change. Systematic traders should estimate volatility on a fast window (e.g., 1 month) and correlation on a slower window (e.g., 6 months) to accurately target risk without over-trading.

Quotes

• At 0:06:09 - "CTAs generally will have positions that are a function of two things: the strength of the trend and the volatility of the instrument you're trading." - Rob Carver defining the core drivers of Trend Following positioning.
• At 0:06:53 - "Some CTAs take volatility into account when they initially buy a position, but then don't make any further adjustments to that position as volatility changes." - Rob Carver distinguishing between static and dynamic risk management.
• At 0:10:05 - "What they would have done is seen the value of the silver in their portfolio kind of get bigger and bigger and bigger... and not done anything about it... and as a result basically would have seen a massive run-up in value and then Freaky Friday would have resulted in a quite substantial drop in value." - Rob Carver explaining the danger of failing to rebalance or volatility-adjust during a trend.
• At 0:13:58 - "If you look at the volume and the open interest numbers and you think, 'Well, I can build up a pretty substantial position here'... then the price starts to move adversely against you... everyone gets jammed trying to get through the exit at the same time." - Rob Carver on the illusion of liquidity during market stress.
• At 0:15:06 - "In market crises, liquidity disappears. And that happens everywhere." - Rob Carver on a universal truth of financial markets.
• At 0:16:58 - "The two key things about risk management are position sizing and diversification." - Rob Carver simplifying complex risk management into two fundamental pillars.
• At 0:32:01 - "Discretionary Rob sold all of his equities in April last year... Systematic Rob is up 20-25% since then." - A practical example of why systematic rules often outperform discretionary emotional decisions in trend following.
• At 0:42:56 - "Volatility is much more predictable than correlation... but correlation is still pretty predictable... If you do a regression of next month's volatility on last month's volatility, you get an R-squared of about 0.35." - Rob Carver explaining why dynamic estimation of risk parameters is superior to using static assumptions.
• At 0:49:26 - "The key thing that's interesting about these alternative and esoteric markets is that a much bigger proportion of their returns are idiosyncratic; they're not coming from these big factors." - Identifying the true value of alternative markets: they provide returns that are uncorrelated to general market cycles.
• At 0:51:11 - "It looks like a lot of the return in my trend following portfolio is actually coming from a kind of risk-on / risk-off factor... If you look at 2008 for example... equities went down... that was a perfect example of that factor in action." - Explaining that trend following returns often come from capturing major beta moves.
• At 0:56:56 - "When is cash efficiency most important? It's when we need cash... when the world's ending." - A critical lesson on why portfolios must balance illiquid assets with liquid, cash-efficient traditional markets.

Takeaways

• Implement dynamic position sizing that inversely correlates with volatility; as an asset's price goes parabolic and volatility expands, automatically reduce your position size to lock in profits and reduce crash risk.
• Do not trust high trading volume as a proxy for liquidity; in your risk planning, assume that during a panic event, liquidity will disappear and you may not be able to exit large positions at your stop price.
• Diversify across "Esoteric" or "Alternative" markets (like specific commodities) to capture idiosyncratic returns that do not move in lockstep with the S&P 500 or global interest rates.
• Maintain a substantial core allocation to highly liquid "Traditional" markets (futures/bonds) to ensure you have cash efficiency and liquidity access during systemic financial crises.
• Separate your calculation windows for risk parameters: use a faster lookback period to estimate volatility (to react to market stress) but a slower lookback period for correlation (to avoid excessive trading costs).
• Adopt a "Total Portfolio Approach" where every new trade is evaluated not on its own merit, but on how it impacts the overall risk and correlation profile of your existing holdings.