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The Monster Under My Bed

I was once asked, "As a money manager, what keeps you up at night?" At the time I had no good answer, but gave the question quite a bit of thought. Generally, market movements and volatility don't bother me in the least (we implement a low volatility strategy). Instead, what keeps me up at nights is the likelihood of a major change in population growth rates.

For the better part of human history the global population has remained tame. Archeologists believe that the human population got as low 1000 people before extinction was real possibility. Slowly, our species clawed back and remained under 100,000 people for thousands of years, until the advent of farming. Within 30,000 years of the birth of farming small cities started to spring up. Indeed the earliest city found, Mureybet (modern day Syria), dates back to 8000 BC with a population of 500. Rome, during the life of Christ, was the world's largest City with a population of 1,000,000. Today, the largest city is Tokyo with a population exceeding 30,000,000.

Currently, the human population is growing at about 1.3% per year with a doubling time of 54 years. At this rate the global population will grow to 12 billion people by 2054 and 24 billion people by 2108. By 2780, the world density would be such that one person would inhabit every square meter of earth. By 4400, the mass of people would be greater than the mass of earth (see video). There is no doubt that human population growth rates will change well within 780 years. Paul Ehrilich wrote that the optimal size of the planet is roughly 1.5 to 2 billion people. Others have estimated the carrying capacity of the earth to be closer to 3 billion people. By any calculation, we are well beyond the sustainable carrying capacity for the planet and we are still adding new people to the planet in an exponential fashion.

Growth is the backbone of all asset valuation. Corporate value is derived from their ability to sell more Bigmacs or Pepsi's or laundry detergent to more people tomorrow than they did yesterday. Appreciation in home prices come from increased demand for a place to live over time as more people are added to the demand side of the equation. Recently, I discussed this concept with a friend of mine who holds a CFA designation. His response was, "You're absolutely correct, all of the theories and all of the equations, everything, boils down to a bet on future marginal growth." To better understand this point, take a look at Facebook. Facebook currently has roughly 900,000,000 users. This equates to roughly 13% of the global population. In 1800, the entire global population was roughly 978,000,000. If Facebook had the same market share in 1800 they would have had roughly 113,000,000 users. This is a dramatic difference and clearly Facebook's value would be much less than it is today. Moreover, many businesses have large fixed costs and infrastructure that require a bare minimum user volume to cover those high fixed costs. Think FedEx.

The United States has enjoyed roughly 5% GDP and 9% stock market growth for most of the twentieth century. Analyze the 9% stock market growth, but take into account inflation of roughly 3% and population growth of 2.5%. That leaves 3.5%, which is roughly the historical dividend rate. Using this math if the human growth rate fell to zero market returns would fall to equal inflation plus dividends. Moreover, if the human population were to reverse you would quickly erode all returns.

At some point, human population growth will slow to a flat line and most likely decline, this is FACT! Portfolio managers need to understand this is a very real risk and have safeguards in place. The H1N1 flu epidemic was one of the largest threats to a major population reversal in some time. The Wall Street Journal recently wrote that the death toll has turned out to be roughly 15 times what was originally estimated (see below). As you can see, high population densities combined with global travel has created a situation that can get out of hand very quickly. And this is just one example of one variable that can change the population growth rate.

Our view is that the human population will continue to grow until it reaches a tipping point at which point it will reverse. During the climb higher natural resources will increase in value as the world reaches its max capacity. Large periodic shocks will become more pronounced do to larger population densities and global travel. Shocks, like that of H1N1, will cause quick panics and steep sell offs of the very natural resource investments that had done so well prior. At some point there is a good likelihood that a reversal of population will be more than a shock but instead longer term in nature. At this point having a good risk control system for your investments will be critical as gluts become widespread.

Some of the largest investment losses in history have come from mispricing tail-risk. Clearly, exponential population growth creates a situation where tail risks are significant both on the way up, and, eventually, on the way down. While tail risk management has become a common term in money management it is usually practiced in name only. Understanding the extremes that come with tail risks are complex. Investors often don't even know what they don't know. Nassim Taleb's book, The Black Swan, details how some of the biggest shocks in human history were completely unknowable beforehand. One of the largest challenges in risk management, at the portfolio level, is checking your ego at the door. The only way to effectively deal with tail risk and black swans is to understand that you will never be able to time everything perfectly. By doing so, the Investor will naturally look to find a more robust method of trading and naturally shy away from ones that perform perfectly, rather than fails perfectly. For more on "trading with large ego's", from the perspective of those who created trading methods, performed perfectly, and then failed perfectly… check out The Rise and Fall of Long Term Capital Management, where Nobel prize winners traded for perfection instead of robustness.