E266: J.P. Morgan CIO: Mistakes Top Investors Make

0:00So Hamilton, you're head of U.S. equity derivatives at J.P. Morgan. What does that mean exactly and what do you do on day-to-day basis? Sure. So I've been at J.P. Morgan since the end of 2009. And my responsibilities today are I have three hats I wear, David. The first one is I'm CIO of our U.S. core equity platform. I'm a portfolio manager on numerous strategies. And in addition, I am the head of U.S. equity derivatives within equity asset management. A lot of that goes back to my background, over 35 years of investing in equities and equity options. And why would an institutional investor want to own an option?

0:36Options are magical. And the reason I think they're magical is because they give you the ability to express a more precise vision or expectation around a stock. Meaning, if you like a stock, you can buy it. And then it's very linear. It goes up, you make money. If it goes down, you lose money. But if you like a stock, you could buy a call. You can buy a call and sell a call. You can buy a call, sell a put. You can sell a put to get your exposure. So it gives you something a little bit more precise based upon your view, your opinion on a security. When I've thought about options throughout my career, it's never been about leverage.

1:10It's about getting that precise way of expressing a view that does not have that traditional linearity, if you will, meaning up I win and down I lose. options, I think, give you that pun intended optionality out to express a viewer and opinion. And like I mentioned, you're a head of U.S. Equity Derivatives. So you run this for JP Morgan. What percentage of your clients are utilizing options in order to hedge their positions and how many of them are leaning into them and trying to establish a view in the market? Sure. So throughout the strategies that I manage, about 40 % of those assets are in people looking to, you know, call it hedge their exposure.

1:53But it's not about hedging your exposure. It's rather about having some type of downside protection or downside buffer, if you will, so you can stay invested. So think about hedging in many cases as a way to not only get invested, but more only stay invested. And then the other 60 % are people that are seeking income, potentially for going some of the upside of the market in return for that bird in the hand of income today. And that's kind of the long-term use cases of options. Options were started on exchange in the early 70s, but actually have been used for over a century by farmers in some shape or form, where either farmers were looking to protect their crops, hedging, or in the case of trying to know what they'll be able to sell their crops for when they harvest them, income.

2:40That one is also important because imagine if you were a farmer back 100 years ago and you planted some crops and the two biggest risks you had were, number one, something unfortunate happening to your crops just as you're about to harvest them. So you'd want to hedge it. The other thing was I have no idea when I plant my crops what I'm going to be able to sell it for when they come due to harvest and somebody says, well, I'll pay you$40 for your wheat today. You'll give it to me in three or four months. And you say, you know what? I'll take the 40s and it costs me 20. I'm blocking the$20. If it goes above 40, you're happy that you were able to lock it.

3:13You gave up a little bit, but you're happy you're able to get the 40. But if it goes below 40, you're really happy you're able to lock it in. That's how I think about hedging and income. Income is about getting income today in return for giving some of the upside. and hedging is about truly finding a way to sleep a little bit better at night with your investment, whether it be your crops or your equities. To use that example, by giving up the upside from$40 and higher, you get income today. So you're being compensated for giving up that upside. Yes, exactly. There's no free lunch, David. There is a trade-off between those two things that you're trying to accomplish.

3:51But let's say stocks are up 40 % this year. you might be concerned about the stock multiples. Let's say you wanted to stay in the market. How could options help you accomplish that? And what do your clients do in those kinds of situations? Sure. So when we think about whether it be income or hedging, we think about it at the portfolio level, but that portfolio level could be also be done at an individual stock level as well. So let's just say there's a stock ABC and it's up 40%. There's a couple of things you could consider. The first one is, you know, you've accumulated quite a amount of wealth on that stock and it's done quite well.

4:27And you want to find a way to lock in some of that gains you've had year to date. So you could buy a put and that put, what it would do would say, if that stock were to go below a certain level, you would no longer lose any money based upon that stock going below a certain level. So if the stock were 100, you know, and it started the year, let's call it 70, and it was up 40%, you know, you would say, you know what, I'm going to lock in, you know, all those gains up until 90. Now you could actually lock up everything up to 100, but the higher that protection is, that higher that put is, the more expensive it is.

5:08But once again, we talked about being able to create a more precise investment experience by using option. So that's kind of one way of trying to lock in some of your gains and protect some of your winnings, if you will, in that stock, or even at the portfolio level. But there's another aspect to it. And that is, perhaps you don't want to lock in those gains per se by buying downside protection. But you also, at that point, say, you know what? I would actually probably sell of this stock if it went to 110. So now all of a sudden, instead of buying puts, you could actually sell a call at 110 on a portion of your portfolio.

5:46If the stock goes to 101, 102, 103, 104, 105, you get all that upside appreciation plus that options premium from that call that you sold. If it were to go to 111, 115, 120, the amount of options that you sold based on how many shares you had, that stock you would actually have to deliver to somebody. But you would have continued upside appreciation plus the options premium, but you would actually have to deliver that stock to the person that bought that option from you. So once again, it comes back to what are you looking to accomplish with your portfolio? How can options complement the experience you're trying to give yourself in that portfolio, David?

6:28So in both of those cases, whether you're buying when the market goes down or you're selling if it goes up in the future, you're basically getting paid to take the right action. So taken to the extreme, the market goes up 200%. It goes from 100 to 200. You know, you're going to take some money off the table because likely it's overvalued to some extent. It's the same thing if it went to 50. It's unlikely that the same stock and the same portfolio is worth 50. You can make that decision ahead of time. And by making that decision ahead of time, which is to force yourself to sell at 200 or force yourself to buy at 50, you're being compensated.

7:05And it creates good discipline. The challenge is when many people, including myself, think about investing, if a stock were at 100, most people would say, I'd buy more down 50%. But once it's down 50%, you have to realize there could be a reason why it's down 50%. And so you still have to be comfortable. So you don't want to do, let's call it a full position from that perspective. You want to do a portion because it's easy, not easy. It's understandable that many of us don't ever think that a stock could go down 50 % or even up 50 % for that matter. So doing a portion, I think is best practice because that way, if it does go there, it gives you a chance to actually reconsider for a larger position.

7:46Do I still really want to buy the stock down 50 %? Do I really still want to sell some more of the stock up 50 %? So it does create discipline, but you also have to be aware that you can't suffer from buyer regret or seller regret because you're doing this in advance, as you said earlier, David. I can't help but think about Rene Girard's mimetic theory, which is that human beings copy the behaviors of others, which is why we have these cycles oftentimes. When things are going up, everybody gets excited. Everybody else gets excited. There's this contagion of optimism. When things go down, you have this contagion of pessimism.

8:15So acting rationally almost goes against our very evolutionary wiring. It's much easier to do when you're at 100 to kind of make those pre-bake those decisions. It is. And it also creates good discipline. I mean, when you think about rebalancing your portfolio, it's never easy to take profits and reduce some of your stocks and buy some more bonds in that rebalancing your portfolio. Constantly rebalancing is one of the best ways of compounding wealth over time. Or the opposite. in March of 2020, the best thing you could have done if you weren't comfortable buying stocks because you're so scared of COVID and what could happen, or even in liberation, the end of the first quarter, liberation at the end of the first quarter, nothing's ever easy, but just sticking to a disciplined approach to investing, buying more stocks when they go down to rebalance your portfolio back to its target state, or even selling some stocks to stay at its target state enables you to navigate storms and markets and uncertainty in a more holistic and comfortable way, if you will.

9:15I want to get to March 2020 in a bit, but first I want to double highlight what you said about when the stock market is up. So it's gone from 70 to 100. The biggest behavioral mistake you can make is actually getting out of the market. So if you zoom out any 10-year period going back to, I think, 1930s, 1940s, every 10 years, the stock market goes off. Sometimes, obviously, it's at a local maximum. Sometimes it's only up by 5-10 % over 10 years. So the right time to buy is always now. And if you take that to the next logical point to that is there's never really a great time to sell if it's always a good time to buy for a long-term holder.

9:54So when you have this market go up and you sell, let's say you bought at 70, you sold at 100, now it's at 120, the incentive to keep on buying in and admit that you were wrong before, there's a counter incentive to do that. So buying insurance against a downturn so that you stay in the market is incredibly underrated behavior. I wouldn't call it insurance because FINRA does not allow any of us to call options insurance. So I would actually say that it's the ability to own an asset that would mitigate some of the downside, not all of the downside. But you're right. When you think about car insurance, which really is insurance, we all have it.

10:32And we all hope that we never need to use it and it never comes into play. But it enables us to drive on rainy roads, icy roads, sunny roads, what have you. and when you come back, investing is about putting money to work and it's also about putting money to work in a way that you feel the most comfortable from a risk perspective. If you are an investor that loses no sleep at night and can navigate the ups, the downs, the wiggles, the waggles, you're right, you know, basically stocks that never lost money over a 10-year rolling period and if you're a young investor, you should probably have a significant amount of money invested in the market based upon your timeline and your horizon.

11:14But if you're that nervous Neil or that nervous Nelly, your amount of equity you should have should be, in my mind, this is one person's opinion, should be commiserate with never having to utter those three ugly words of get me out. You should feel comfortable with markets going up, down, sideways. And if they happen to go down, you're actually in a position to be able to add more because of your risk tolerance from that perspective. I think the biggest cardinal sin is people that have a mismatch with their risk tolerance and their investing. So everyone is happy, happy and high-fiving when the market goes up.

11:50But those people that are still comfortable with their holdings when the market goes down probably have a better understanding of their risk tolerance. When you think about the financial advisor community, they have clients that are conservative, moderate, and aggressive. The real question is, is that person still aggressive when the market goes down 5 %? If the answer is yes, their allocations are correct. If the answer is no, then they're only aggressive in a one-way market. You need to be aggressive or moderate or conservative in a market that can go up or down. Because as you said earlier, David, stocks over a 10-year rolling period historically have gone up, but it's never a straight line.

12:30There's always every decade a thing, whether it be the tech bubble. I mean, I've been doing this since the late 80s. So you had the 87 crash. You had the 89 United Airlines kerfuffle. You had the early 90s Gulf War. You had the end of the 90s. You had the Thai bot and long-term capital. Then you had the tech bubble. Then you had the GFC. And then you had the U.S. debt getting downgraded in 2011. And then you had, you know, in 2015, you had some of the challenges around oil and some of the other situations. and then 2020, and then 2022. It happens. These things happen. Liberation Day, just more recently, these things happen.

13:14And the best thing that any of us can do as investors is not only get invested, but most, most, most importantly, is stay invested. And options, I believe, specifically hedged strategies, help you stay invested. I would almost say, forget the fact that it uses options. It does, but forget the fact it uses options. it's Mr. or Mrs. Investor. Are you okay making some of the upside if in return you don't have all the downside? How you get to that by using options is how the sausage is made, but how to use the sausage, how to think about the sausage, how to think about a hedge strategy is exactly that.

13:51Making some or most of the upside in return for not having all the downside. It's interesting because the unpredictability of the market, so it might have a 8 % to 10 % expected return and let's say a 10 % standard deviation. So some year it'll be down 2%, some year it'll be 18%. That is actually the feature because if it went straight up, it would be more like a bond. And if the return was more predictable, it wouldn't have that return. So the question becomes, can you deal with the ups and downs? I had Julia Reese, whose job was for a decade to go and meet with the CIOs of foundations, endowments and pension funds, Goldman Sachs' top clients.

14:27And what she found was this, the volatility and the selling was directly this nasty chart where every time there was a drawdown was when the selling occurred. So a lot of people think of markets as this linear instrument, but a lot of wealth is actually created and lost in those downturns. There's 10 % plus markdowns. I'll give you another cool stat, I think, Dave, and that is over the last 20 years, a fully invested equity portfolio is up approximately 10.5%. If you miss the 10 best days, that number goes from 10.5 to about 5.5. But many people would say to me, Why would you ever think I missed the 10 best days?

15:04Am I that bad a stock picker or market timer? Well, seven of those 10 best days happened within two weeks of the worst days, of the 10 worst days. Think about that for a second. When are people most likely to make those irrational and maybe suboptimal decisions? Within two weeks of those worst days. So it's not that you're not a good stock picker, not a good stock timer, but when do you really have to think about that behavioral component to investing? it's around those worst days and if seven of those 10 worst days were within two weeks then it's likely you hopefully made the right decision by staying invested but it's also likely you had to make that decision it sounds like when you say these 10 days it sounds like some some meaningless marketing drivel yes if you cherry pick these 10 days randomly you're not going to get that return but when people are systematically selling exact two weeks behind before those 10 days then that starts to illuminate.

15:59I used to try to develop and cultivate myself this steady hands, this in crypto hodl, right? These ability to withstand crises. And then I listened to an interview with Stan Drunkenmiller and he said, nothing looks as cheap as after it's gone up 40%. And I had an epiphany, which is rather obvious, which is if one of the greatest traders of all time, Stan Drunkenmiller, struggles with trading and not prescribing to when things go up, buying more and when things go down, selling less. Maybe what needs to be done is not to cultivate this kind of strong hands, but it's to structurally create a portfolio that does not require this heroic action.

16:37That's when I started to look at things like illiquidity. I have this whole paradoxical belief. Illiquidity could have a lot of virtue. In fact, when I interviewed a lot of the top crypto investors, like the top decile fund investors. So think of there's hundreds of millions of crypto investors. There's these elite fund managers that a small percentage of the population has said can hold their assets and then there's top desol of them both privately and publicly they admit that their best investments are actually their illiquid ones in other words it's the illiquidity that made their returns good not actually the picking picking and choosing of different cryptocurrencies and there's something set at um to be said about that because you don't have to make the decision to sell when you can't it's unilateral you know i'm married to this position because illiquid.

17:25But I'd also say those illiquid positions, if I were a betting man, had underlying fundamentals, underlying valuations, underlying things about them that attracted people to them. There's plenty of illiquid stuff that could be a little schlocky, right? That just doesn't have the right reasons to own it. But to all those wonderful, great investors publicly and privately to share with you, some of the best investments were illiquid, it's the underlying fundamentals. I mean, the things about those securities were the same, whether it be public or private, but because they're illiquid, they didn't have to make that decision up to buy, hold, or sell.

18:05They were holding them because there was no choice. Previous guest Cliff Asnes calls this volatility laundering. He complains that private equity funds only have to mark their books once a quarter. I actually think that's the feature of the asset class. A lot of people will say on this topic, sure, retail investors, grandma, you know, my mom might have weak hands, might sell at the exact wrong time. But surely institutional investors are not prone to this bias. And then when you look at the governance at institutional investors, you see the ultimate poor decision making governance for these kind of decisions, which is committee.

18:38You have these 10 people committees. And if only one or God forbid, two people on that committee are panicking, you are going to have a contagion and you are going to have this compromise of selling a big portion of the portfolio. And this is something that we see over and over, regardless of market cycle for decades, ever since the early 20th century. So investing is about risk. There's no getting around it. You have risk when you have an investment. The question is, what is the magnitude of that risk? And if you were in a committee-like approach, you are subject to, I told you so. And nobody wants the, I told you so, whether it be personally from your significant other or professionally from your investment committee.

19:17And so when I think about investing, it is behavioral. And I'm not a big fan of using the term all-weather portfolio. I'd rather say balanced portfolio. And many institutions do it quite well, David, where they have some private, some public, some fixed income, some extended fixed income, and they don't have all of their eggs in one basket. Because when I think about investing, it goes back to what I was talking about. It's about risk tolerance. So I don't start, and I don't think people should start with asset allocation, stocks, bonds, alts. I need some of all of them. No, my belief is you used the word standard deviation before.

19:58Standard deviation is volatility. It's a range of outcomes to your portfolio. It's a range of outcomes to a stock, to a bond, to a private. And so I think portfolios are, you start with how much risk can we take as a pension, endowment, foundation, individual? And then how do I fill that bucket of assets? And it could be in stocks, bonds, alts, privates to actually meet that targeted risk profile, such that you can actually, at a committee level, individual level, or a CIO level, stay invested. Because if you have a portfolio that's well-balanced to risk and the market goes down, you can all look around the table and say, you know, markets are down 20 % and we're only down 8%.

20:42We're only down 10%. We've done a good job in creating a well-balanced portfolio. Now, if you're chasing returns and you're 100 % in stocks and you're down 20 % or maybe even more, the market down 20, then there's this, oh my God, what if we continue to go down? What if we're down another 5, 10 or 15 or 20? And I love how you quoted Stanley Druckenmiller because everyone harkens back to March of 2020 saying it was a generational time to buy the market. On TV and on radio and on podcasts, there were numerous people calling for the end of the world saying we should close markets till Labor Day, saying that this is terrible and getting worse.

21:19We're shutting down the economy, all these things. But it was a generational opportunity by the market if you had the ability or the risk tolerance or the risk available to put some money to work. Or the best thing you could have done at the very least in March of 2020 was not sell. Because once you sell in March of 2020, you'll never get that money back. I have a prideful moment in March 2020. I had the opportunity. Sequoia was doing a round into Robinhood. And this is this golden grail to invest alongside Sequoia directly on CapTable. and I hit up a bunch of family offices that have been asking me for years for this impossible Sequoia Co-investment in a top company.

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23:44But this whole COVID risk to me was not a real risk. It was kind of things are going to happen the way they're going to happen. We didn't know at that point. We didn't know maybe it would be like the black plague and maybe society will be wiped out. But regardless, I wasn't worried about that outcome from an investment standpoint. I agree. And let's just bring that back for a second to my background in equities and equity options. Everyone calls the VIX the fear index, and it's not about fear. It's a measurement of uncertainty. When the VIX is higher, it's because there's more uncertainty in the world or the markets.

24:18In March of 2020, the VIX, I think, went to 50, 60. There was a lot of uncertainty. There was a greater range of outcomes from any investment. And range of outcome does not mean down. It means up or down. So that's why in the second quarter, when the markets ripped about 20%, people should not have been surprised by that magnitude because the VIX was projecting a greater range of outcomes. It could have been down 20 or up 20. But the fact is, is that that is, in my mind, an opportunity where your job as an investor is to scale your investments appropriately, as well as take that as an opportunity to put money to work or to reallocate.

24:57In 2020, there are certain asset classes that did their job for you, whether it be puts or bonds or, for that matter, cash. But then when the market gives you this opportunity to be risk-efficient or risk-opportunistic, You should put money to work. But once again, the higher the risk, also the higher potential reward, which means you don't need to put as much money to work. If your normal investment in the market is$100, when the VIX is$60, you really only need to put$20 or$30 to have the same opportunity as a normal environment. I actually want to double click on that because alongside being head of U.S.

25:33equity derivatives, you're also the CIO of U.S. core equity at J.P. Morgan. There's an orthodox belief that volatility is bad. In fact, the entirety of modern portfolio theory is about how do you maximize return while minimizing standard deviation. But you said something there, which is sometimes risk in small doses could be extremely good. Let me give you a thought experiment. Let's say that U.S. equities had a 20 % return with a 20 % standard deviation. Obviously, you wouldn't size it the same. You wouldn't put 60 % of your portfolio into that. But would that be, in some ways, a better asset class than 10 and 10?