Better Brakes, Faster Gains: Unlocking the True Power of Convexity in Outlier Hunting
Better Brakes, Faster Gains: Unlocking the True Power of Convexity in Outlier Hunting
David Dredge, the founder and CIO of Convex Strategies, recently shared powerful insights on risk and growth during a thought-provoking podcast discussion. His key message: better brakes enable faster driving. While this analogy was originally applied to robust downside protection strategies like tail-risk hedging, the underlying principles of convexity and compounding are equally relevant to the systematic approach of Outlier Hunting. This blog dives deep into these concepts, demonstrating how Outlier Hunting balances risk and reward to achieve geometric compounding and long-term outperformance. For those eager to hear David Dredge’s full discussion, we’ve included the podcast episode after the conclusion to this post —an essential listen for anyone interested in the interplay of risk, reward, and market dynamics.
David’s insight about “better brakes enabling faster driving” reveals a deeper truth about how to balance risk and opportunity. While the metaphor originally referred to robust downside protection, its application to Outlier Hunting goes far beyond just mitigating losses. In the world of trend following, better brakes represent the convexity that empowers you to pursue extraordinary gains from market outliers with confidence.
Convexity in Outlier Hunting isn’t about caution or avoidance—it’s about positioning systematically to benefit disproportionately from the extreme moves that define market returns. By dynamically managing risk, convexity ensures that you remain exposed to trends for as long as they persist while limiting the drag caused by losing trades. This dual dynamic—protecting the downside while amplifying the upside—is the cornerstone of geometric compounding and long-term outperformance in markets.
Outlier Hunting takes this principle a step further. It operates on the understanding that markets are not normally distributed; instead, they exhibit power-law behavior, where a small number of extreme moves drive the majority of returns. These outliers—be they the explosive rise of a commodity like Cocoa, the unprecedented volatility in Orange Juice, or Bitcoin’s meteoric ascent—represent the “straightaways” in the investment race. By having the right “brakes” (convexity), you can accelerate through these market opportunities with confidence, knowing your process is designed to navigate the unexpected curves along the way.
Where traditional approaches fear volatility and attempt to smooth it away, Outlier Hunting embraces uncertainty. It thrives in the dynamic, fat-tailed nature of markets by dynamically adjusting exposure to trends, enabling you to capture transformative moves while systematically avoiding ruinous losses. Convexity isn’t just about survival—it’s about thriving in the chaos, turning market noise into opportunity.
By building convexity into your process, Outlier Hunting transforms volatility from a risk into a driver of returns, empowering you to aim higher, push harder, and position for the extraordinary gains that ultimately define your portfolio’s success.
The Race Car Analogy: Hunting Outliers without Convexity
Imagine you’re in a race car on a 40-lap course filled with sharp curves, blind spots, and long straightaways. Without brakes, you’d approach each lap with extreme caution, creeping around every curve and hesitating on the straightaways for fear of losing control. While others speed ahead, taking calculated risks and recovering gracefully from tight turns, your progress is limited by fear and inefficiency.
This metaphor mirrors the experience of investors who lack a systematic approach to managing risk and capturing outliers. Without a robust process like Outlier Hunting, they focus excessively on avoiding volatility, treating risk as something to be eliminated rather than a tool to be harnessed. These investors aim for “average” market conditions, missing the extraordinary opportunities that arise from trends and outliers.
In the context of Outlier Hunting, convexity acts as the brakes that allow you to accelerate. It empowers you to embrace uncertainty, knowing your strategy is built to adapt to whatever the market throws at you. Convexity ensures that you can take bold positions in markets showing strong trends—like Bitcoin during its exponential rallies or Cocoa in its recent historic move—without the fear of being blindsided by sudden reversals.
Without convexity, investors are paralyzed by uncertainty, mistaking short-term noise for insurmountable risk. They slow down on the market’s straightaways, leaving gains on the table, and are ill-prepared to navigate the inevitable curves that arise in complex, dynamic systems like financial markets. In contrast, a robust Outlier Hunting process thrives in these conditions, systematically identifying and exploiting trends while maintaining the flexibility to respond to changing market dynamics.
By embracing convexity and the principles of Outlier Hunting, you aren’t driving cautiously through the markets—you’re positioning yourself to confidently chase the extraordinary moves that truly matter. You’re not just surviving the race; you’re winning it.
Convexity: The Engine of Outlier Hunting
Now, imagine that same race car equipped with cutting-edge brakes—not just tools for slowing down but enablers of precision and speed. These brakes don’t merely prevent crashes; they give you the confidence to accelerate on straightaways and take curves with agility. In Outlier Hunting, convexity is not just a safety mechanism—it is the engine of growth, allowing you to harness the market’s potential for extraordinary gains.
In Outlier Hunting, convexity operates in three key ways:
- Cut Losses Short:
In Outlier Hunting, losses are treated as part of the process, but they’re kept small and manageable. By systematically cutting losses when a trend reverses or fails to develop, you avoid the kind of catastrophic drawdowns that derail long-term compounding. Think of it as tapping the brakes lightly on a curve, keeping control without losing momentum.For instance, when a market like crude oil begins to reverse after a breakout attempt, a systematic trend-following model will exit the position without hesitation, conserving capital for the next opportunity. This discipline ensures that your portfolio remains resilient and ready for the next big move. - Let Profits Run:
Outlier Hunting is all about capturing the full extent of rare, powerful trends. When a trend develops, convexity allows you to stay in the trade and ride the wave. Think of it as accelerating smoothly on a straightaway, confident that your strategy is prepared to handle the curves ahead.Consider the dramatic rise of Cocoa. A trend-following strategy wouldn’t have exited after a 20% or 50% gain—it would have stayed in the trade until the trend showed clear signs of exhaustion. Indeed as at the date of writing this blog, you will still be enjoying the bull ride of Cocoa. This principle of letting profits run is the cornerstone of capturing outliers, where a single trend can make a significant impact on long-term returns. - Capture Outliers:
Markets are defined by their extremes. The biggest gains often come from a small number of outliers, such as Cocoa’s historic rally in 2024 or the surprising strength of Orange Juice. Convexity ensures that your portfolio remains exposed to these opportunities, positioning you to capitalize on rare events that other strategies miss.By diversifying across uncorrelated markets, Outlier Hunting increases your chances of catching these transformative moves. It’s like racing on multiple tracks simultaneously, ensuring that no matter where the straightaway appears, you’re positioned to take advantage.
Outlier Hunting as Convexity in Action
Where traditional portfolios focus on smoothing returns and avoiding volatility, Outlier Hunting embraces the dynamic nature of markets. Convexity allows you to do more than survive market fluctuations—it enables you to thrive in them. By balancing risk management with growth, Outlier Hunting turns market uncertainty into a competitive advantage, leveraging small, controlled losses to pursue massive gains.
The combination of cutting losses, letting profits run, and capturing outliers is what makes convexity the engine of success in Outlier Hunting. It’s not just about having brakes; it’s about knowing when to accelerate, when to slow down, and how to position yourself to win the race.
The Problem with “Sharp World” Thinking and the Opportunity in Outlier Hunting
David Dredge’s critique of “Sharp World” reveals a fundamental flaw in the way many investors approach markets: they focus on arithmetic averages rather than the power of geometric compounding. This short-term mindset, driven by annual performance benchmarks and a preference for smooth equity curves, creates portfolios that look stable but ultimately underperform. In contrast, Outlier Hunting shifts the focus toward capturing long-term geometric growth by embracing market dynamics, not resisting them.
Why Sharp World Falls Short
- Backward-Looking Risk Assumptions:
Sharp World relies heavily on historical data to estimate risk, assuming stable correlations and predictable volatility. This backward-looking approach breaks down in real-world crises when correlations spike, volatility surges, and markets deviate sharply from their historical patterns.For example, a 60/40 portfolio optimized under Sharp World logic may appear diversified during normal conditions. However, during events like the 2008 financial crisis or the 2022 bond-equity correlation breakdown, the underlying assumptions collapse, leaving portfolios exposed to catastrophic losses. - The Illusion of Diversification:
In Sharp World, diversification is treated as static—a collection of assets that worked well together in the past is assumed to provide the same protection in the future. This illusion fails when market conditions shift, as correlations often converge during crises.Outlier Hunting rejects this flawed assumption by embracing a dynamic, systematic approach. Diversification isn’t just about spreading risk; it’s about exposing your portfolio to the widest range of potential outliers, ensuring that the rare, transformative moves are captured. - Optimizing for “Normal” Conditions:
Sharp World portfolios are built for average conditions, not extremes. This is a fatal flaw, as markets are governed by power laws, where outliers drive the majority of returns. By smoothing returns and avoiding volatility, Sharp World sacrifices the very events that create wealth.
Outlier Hunting: The Antithesis of Sharp World
Outlier Hunting flips the Sharp World mindset on its head, focusing on the realities of market behavior rather than its perceived stability. Here’s how:
- Embracing Volatility: Instead of smoothing equity curves, Outlier Hunting thrives in uncertainty. Volatility is viewed not as a risk to be eliminated but as a signal of opportunity, where extreme trends emerge.
- Targeting Geometric Compounding: By systematically cutting losses and letting profits run, Outlier Hunting ensures that the portfolio compounds over time, minimizing drag from losing trades and amplifying gains from outliers.
- Dynamic Diversification: Outlier Hunting diversifies across markets, ensuring that the portfolio is exposed to a broad range of potential trends. This isn’t the static diversification of Sharp World but an adaptive process that adjusts as markets evolve.
The Consequences of Sharp World Thinking
Portfolios built under Sharp World principles fail to recognize the importance of outliers. They underperform because they:
- Avoid the very volatility that creates opportunities.
- Rely on outdated assumptions about correlations and risk.
- Focus on arithmetic returns, ignoring the long-term impact of compounding.
In contrast, Outlier Hunting positions portfolios to thrive in the non-linear, power-law-driven world of financial markets. By systematically exposing capital to trends and embracing the dynamics of convexity, it captures the outliers that others miss.
In investing, as in racing, focusing solely on the smoothness of the track misses the point of the race itself. Outlier Hunting is about navigating the sharp curves and harnessing the straightaways, ensuring that your portfolio grows geometrically, even in a world of uncertainty.
Geometric Compounding: The Engine Behind Outlier Hunting
At the heart of Outlier Hunting lies the principle of geometric compounding. Unlike arithmetic returns, which simply average gains and losses over time, geometric returns take into account the cumulative impact of losses and gains on a portfolio. This subtle but profound difference explains why convexity—the ability to limit losses while amplifying gains—is the key to achieving long-term outperformance.
Why Losses Hurt More Than They Seem
In investing, avoiding deep drawdowns is critical because of the disproportionate effort required to recover from losses. A 50% loss requires a 100% gain just to get back to even, creating a drag on future compounding.
Outlier Hunting addresses this by systematically managing downside risk through cutting losses short. When a trend reverses or fails to materialize, the strategy exits the position decisively, ensuring that losses remain small and manageable. This discipline prevents the kind of portfolio damage that can derail compounding over the long run.
Example: Imagine an investor in 2024 chasing trends like Cocoa or Orange Juice. Without a systematic approach, they might hold onto positions too long, hoping for a reversal. An Outlier Hunting strategy, by contrast, would have exited as soon as the trend showed signs of failing, preserving capital for the next opportunity.
Capturing Outliers: The Power of Positive Compounding
While limiting losses is essential, the true strength of geometric compounding comes from capturing outliers—the rare, powerful market moves that disproportionately drive returns. These trends are the equivalent of hitting straightaways in a race, where acceleration matters most.
Outlier Hunting thrives by staying in these trends as long as they persist, maximizing exposure to their full potential. By avoiding early exits and allowing profits to run, the strategy turns volatility into an asset rather than a liability.
Example: Take Bitcoin’s explosive rallies. A trend-following system doesn’t predict when or why Bitcoin will rise; it simply identifies the trend and rides it until clear signals indicate it’s time to exit. This systematic approach ensures the portfolio captures the geometric benefits of extreme moves.
The Symbiotic Role of Convexity and Compounding
Convexity is the enabler of geometric compounding. By balancing risk and reward dynamically, convexity ensures that:
- Losses Are Mitigated: The portfolio avoids the drag of large drawdowns.
- Upside Is Amplified: Gains from outliers significantly outweigh the impact of smaller losses.
- Compounding Accelerates: The portfolio grows geometrically, leveraging the full potential of market extremes.
Outlier Hunting is designed to optimize this balance. It systematically manages the downside, preserving capital during volatile periods, while remaining exposed to the upside, capturing the rare moves that drive wealth creation.
Geometric Compounding in Action
Consider a portfolio exposed to 100 markets, ranging from equities and commodities to currencies and fixed income. In any given year, only a handful of these markets may produce significant outliers. The geometric power of Outlier Hunting lies in its ability to:
- Minimize the impact of small losses across the majority of markets.
- Capture exponential gains from the few markets that experience extraordinary trends.
Over time, this asymmetry creates a compounding effect that far outpaces traditional approaches focused on arithmetic returns.
Why Geometric Compounding Matters More Than Ever
In today’s complex, interconnected markets, volatility is the norm, not the exception. Investors who embrace this reality—through strategies like Outlier Hunting—position themselves to benefit from the uncertainty that others fear. Geometric compounding isn’t just a mathematical principle; it’s the foundation of a robust investment process that thrives in a dynamic, ever-changing world.
Actionable Takeaways for Outlier Hunters
For investors committed to Outlier Hunting, success lies in combining a clear understanding of market dynamics with a disciplined, systematic approach. Here are four actionable takeaways to transform your portfolio:
1. Reallocate from Inefficient Diversifiers
Traditional portfolios often rely on static allocations to assets like bonds or low-volatility equities as “diversifiers.” While these assets may reduce short-term volatility, they frequently underperform during extreme market events and fail to capture the returns generated by outliers.
In contrast, Outlier Hunting redefines diversification. It isn’t about holding many uncorrelated assets for the sake of stability; it’s about systematically exposing your portfolio to markets where significant trends could emerge. This means reallocating from inefficient diversifiers into strategies that can identify and capture outliers, such as diversified systematic trend-following models.
Example: Instead of relying on bonds to balance equity risk, an Outlier Hunting approach might diversify across global futures markets, from commodities like Cocoa and natural gas to financial instruments like currencies and equity indices. These markets provide access to a broad spectrum of potential trends, maximizing the opportunity to capture rare, transformative moves.
2. Embrace Trend Following
At its core, Outlier Hunting is powered by trend-following principles. Markets are inherently unpredictable, but trends—once established—often persist long enough to generate significant returns. Trend-following strategies systematically identify these trends, ensuring your portfolio remains positioned to capture their full potential.
By design, trend-following strategies:
- Avoid predictive biases, relying instead on market signals.
- Cut losses quickly, minimizing the drag from false starts.
- Stay in profitable trends, ensuring you benefit from outliers.
Example: Imagine the year’s biggest outlier emerges in a lesser-known market like orange juice futures. A traditional portfolio would likely miss this opportunity entirely. A diversified trend-following approach, however, would identify the trend as it develops, ensuring exposure to its full impact.
3. Think Beyond Annual Returns
The obsession with annual returns and smooth equity curves—hallmarks of “Sharp World” thinking—hinders long-term compounding. Outlier Hunting shifts the focus from short-term metrics like Sharpe ratios to the long-term geometric growth that defines true wealth creation.
Outliers don’t follow annual schedules. They emerge sporadically, often at unpredictable times and in unexpected markets. Evaluating success over short timeframes risks missing the bigger picture, where a single outlier can redefine your portfolio’s trajectory.
Takeaway: Stop measuring success by year-to-date performance. Instead, evaluate whether your strategy is positioned to capture outliers over the long term. The goal isn’t to win every year—it’s to win big when it matters most.
4. Prioritize Convexity
Convexity isn’t just about managing risk—it’s about unlocking opportunity. In Outlier Hunting, convexity ensures your portfolio can adapt dynamically to market conditions, cutting losses when trends fail and capitalizing on extreme moves when they arise.
This principle is what separates Outlier Hunting from traditional investing. By prioritizing convexity, you position your portfolio to:
- Survive the inevitable market downturns.
- Thrive during periods of extreme market trends.
- Achieve geometric compounding by balancing downside protection with upside potential.
Example: During periods of heightened volatility, convexity enables your portfolio to remain engaged with the markets while avoiding catastrophic drawdowns. This adaptability ensures you’re always prepared to capture outliers, even in uncertain conditions.
- Reallocate from Inefficient Diversifiers: Move beyond traditional assets like bonds, reallocating to strategies that capture trends and outliers.
- Embrace Trend Following: Systematic trend following thrives in uncertainty, systematically managing risk while exposing your portfolio to extraordinary opportunities.
- Think Beyond Annual Returns: Focus on long-term geometric compounding instead of short-term performance metrics.
- Prioritize Convexity: Seek strategies that dynamically balance risk and reward, enabling your portfolio to adapt to market extremes.
Conclusion: Outlier Hunting in Action
David Dredge’s insights serve as a powerful reminder that success in investing isn’t about avoiding risk—it’s about managing it effectively. The principles he discussed, from convexity to geometric compounding, highlight the importance of balancing downside protection with the ability to capitalize on extraordinary opportunities.
In Outlier Hunting, these principles are brought to life through diversified systematic trend-following strategies. By dynamically managing risk, cutting losses short, and letting profits run, this approach transforms market uncertainty into a driver of long-term growth. It thrives on the extremes—the rare outliers that traditional portfolios often miss—while maintaining resilience during periods of volatility.
The race car analogy perfectly captures the essence of this mindset. Investors without brakes (convexity) are forced to drive cautiously, leaving gains on the table and risking catastrophic losses on sharp curves. In contrast, those equipped with robust systems like Outlier Hunting can navigate the curves with confidence, accelerating through the straightaways and positioning themselves for geometric compounding over time.
As you consider your own investment approach, ask yourself: Are you stuck in the slow lane of “Sharp World” thinking, optimizing for short-term metrics and static diversification? Or are you ready to embrace the dynamic, adaptive process of Outlier Hunting, where capturing market outliers and thriving in uncertainty becomes the cornerstone of your success?
The choice is clear. Outlier Hunting isn’t just a strategy—it’s a philosophy for excelling in markets defined by complexity and change.
For more insights, listen to the full podcast episode featuring David Dredge below and see how these principles can transform your approach to investing.