Why Convexity Matters: Efficient Downside Protection, More Upside Participation
- By David Dredge
- 4 min read
‘If something cannot go on forever, it will stop’, states Stein’s Law. We keep this top of our minds. Clearly, central banks cannot forever maintain policy settings at one extreme as economic circumstances, whether growth or especially inflation, push to the opposite extreme. Something must give. It is the classic fat-tailed distribution: high expectations around the mean and very wide variance.
The investment solution to this dilemma remains the same. We should structure our portfolio for what we do not know (the wide variance), not what we think we know (the probabilistic mean). Compounding is driven in the wings (the extremes). It is just math. We want to participate in the unexpected upside – for example, central banks carry on and continue to drive asset values to historic levels without blowing things up. But we want to cut off the unexpected downside – for example, things blowing up. We want our portfolios to be convex!
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