The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioural discipline that are likely to get you where you want to go.”
— Benjamin Graham, The Intelligent Investor, pg. 220
I tried to distill how I think about investments into three elements. Here they are.
Have an edge by being rational
“Investing is not a game where the guy with 180 IQ beats the guy with 160 IQ”, said Warren Buffett, and I agree.
Making investment decisions is no different than making decisions in Engineering, Medicine or Law. Decisions in each of these fields, as well as investing, involves a high level of uncertainty and a component of probability. You can make a thoughtful, rational decision and still experience an unfavorable outcome (a decision that “went wrong” although it was not actually wrong). In contrast, you can make a lousy decision, or merely speculate, and yet experience a favorable outcome (and everyone will say you are a genius).
Investing can be described as a long series of many decisions, such as which securities to buy and when, which securities to sell and when, how many securities to hold, etc. You can strike well once, twice or even ten times. But unless you have a rational, thoughtful, evidence-based system, statistics will turn against you sooner or later.
I buy into the thesis that humans are predictably irrational. Prof. Dan Ariely and Prof. Daniel Kahneman have researched the topic of rationality in depth, and the evidence they provide cannot be ignored. The professors claim that we all have mental biases that we’re not even aware of. We hold on to losing positions even when prospects are grim; we favor what’s near and what’s recent even when the evidence says we shouldn’t; we anchor on arbitrary rules and figures, and so on. Investing experts provide no relief, as they are human and prone to the same cognitive biases. Moreover, research showed that being knowledgeable of one own’s biases do not help one avoid them. You know you are irrational, but you can’t help but being irrational. It’s just stronger than you.
So what can we do? Well, we’re well into the 21st century, and by now we understand that we can and should utilize technology to help us overcome our inherent biases. And what’s better than a carefully crafted software to make repeated rational decisions involving tons of data? We use computers to diagnose tumors, alert us before when we’re running into a car accident and calculate how thick should be a bridge, so it does not collapse. It only makes sense that we use computers for making investing decisions.
But remember, we do not recklessly put our financial fate in the hands of the computer making arbitrary decisions. We carefully and rigorously craft a rule-based system (a recipe, if you will) for performing in-depth fundamental research by pruning years of SEC filings and market data and applying decisions based on what has been proven to work well.
Systematic decision-making, which relies on models outperforms discretionary decision, even expert opinion.
If you do fundamental trading, one morning you feel like a genius, the next day you feel like an idiot…by 1998 I decided we would go 100% models…we slavishly follow the model. You do whatever it (the model, T.D.) says no matter how smart or dumb you think it is. And that turned out to be a wonderful business.”
—Jim Simons, Founder, Renaissance Technologies
It took me years since starting developing systematic models until I finally took the plunge and started investing my own money according to quantitative models (I’ll add my story to this blog at a later date).
Other prominent quantitative investors had similar experiences. Here’s Wes Grey, one of the best quantitative investors today, describes how he turned 100% quantitative:
(listen from minute 7:50 to 12:00)
The quantitative way to winning in the investing game is through:
- Relying on the right data – avoiding the irrelevant
- Learning from the past – what has worked (with statistical significance)
- Applying rational logic, time and time again
We make repeated rational decisions using a computer running a carefully crafted software based on rigorous research. It is a fundamental component of our edge.
To be part of the 1% you have to stop thinking like the 99%.
Most of us cannot understand how a view held by most people can be plain wrong. In investing, we subconsciously believe that if a stock is priced expensively and enjoying an uptrend, there must be brilliant investment professionals who must know that the underlying company has great prospects ahead. On the other hand, if a stock has declined and it is trading at a minuscule valuation, the company must be doomed. By adopting the majority view on stocks, we wrongly assume that us individual investors and small money managers, share the same goals as the big institutions who manage most of the universe’s wealth.
But it ain’t necessarily so.
Prof. Martin Whitman, a venerable investor who wrote the books The Aggressive Conservative Investor and Modern Security Analysis, teaches us differently. Institutional money managers do seek long-term capital gains, but they are also after short-term gains which they need to preserve their jobs. Being under the scrutiny of colleagues and clients, they often cannot afford holding bad companies (even if they trade at great prices) or temporary-losing positions. Us individual investors and independent money managers can exploit those irrational behaviors for our benefit… if only we do not fall into the trap of groupthink.
The intelligent investor gets interested in big growth stocks not when they are at their most popular – but when something goes wrong.”
— Benjamin Graham, The Intelligent Investor, p.183
Being contrarian is at the heart of value investing. We buy stocks when they are most unpopular and thus – cheap. We sell stocks when the masses realize their value and potential.
Easy said than done.
The challenge is having the guts to buy cheaply. After all, Cheap comes with a mental price tag. It involves holding sick companies, ones with weak financials, a bag of problems and a myriad of concerns. After all, stocks become unpopular for a reason. Great companies with fantastic prospects simply do not trade at a discount (except on colossal market crashes like 1974, 2002, 2008).
In most times the consensus is correct. Opportunity knocks on those rare occasions where the crowd is wrong. The challenge is identifying when that happens.
If we intend to earn any excess returns, we must be contrarians.
But we also have to be right.
To sum, we increase our chance of being right when everyone else is wrong, by investing in cheap stocks, disregarding their temporary performance. Rather, we look for their long-term characteristics. We do so systematically using our computer algorithms, which help us avoid falling into mental traps and cognitive biases.
It works because it doesn’t always work
We all know that there are no free lunches in life. And since only the paranoid survive, you should be asking how come the quantitative strategies portrayed on this website achieve such great returns with relatively low volatility and drawdown?
Where’s the catch?
Well, there is certainly a catch. And it’s a big one. The good news is that if you can live with this big caveat, then nothing can stop you from enjoying outsized investing returns.
The catch is…
It works (well in the long term) because it doesn’t always work (well in the short term).
Quantitative strategies experience protracted periods of lagging the market. They all do. They do not perform well 100% of the time. They can lag the market for many months and even years, as evident from the backtesting reports I am posting on this site.
That’s the reason why most professional money managers cannot employ them. Their clients would simply fire them.
And thus quantitative investing remains a niche… and the opportunity still exists.
Let’s consider the points above with a bit more rigor.
The Efficient Market Hypothesis (EMH) is a theory in financial economics that states that assets’ prices fully reflect all available information. A direct implication of it is that it is impossible to “beat the market” consistently on a risk-adjusted basis. The EMH was developed by Professor Eugene Fama who preached that stocks always trade at fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing. The only way an investor can obtain higher returns is either by sheer luck or by purchasing riskier investments.
Nowadays it is evident, and even Fama acknowledges it, that there are limits to market efficiency. Stock factors (often called Smart Beta) such as small size, value, momentum, low volatility, and quality result in outsized risk-adjusted returns that the EMH has fails to explain.
The question becomes if such anomalies exist, and they are well known, how come they are not exploited by savvy market participants?
Well, they cannot be exploited, i.e., arbitraged away due to the systematic structure of financial markets. In financial jargon, it is called limits to arbitrage. You see, professional money managers manage most of the world’s capital through institutions, be it in mutual funds, endowments, pension funds, hedge funds or other instruments. The public selects most money managers based on recent performance, usually up to 1-3 years. While the exploitation of factors such as small size, value or momentum works well in the long term (3-5 years duration or more), in the short term there will be periods of underperformance ranging one year, two years and even three years. When a money manager underperforms for several years in a row, she will soon be out of a job. Wes Grey has written a seminal article on this phenomenon which is a must for every serious investor – Even God would get fired as an active investor.
And that’s why investing in factors through quantitative strategies remain a niche. As long as most of the investment public is short-term oriented (and I think it’s not about to change anytime soon), quant strategies will continue having an edge.
It works well (in the long term)…simply because it doesn’t always work well (in the short term).
Quantitative strategies have thus gained a following of smart people who understand the power, but also the pains, involved in long-term investing. These investors are willing to suffer a year or two (on rare occasions even more) of being mocked at due to their (temporary) underperformance. But those investors know that if they live through the pain, they will outpace everyone else.
Such investors, like us, take a contrarian approach to markets, and to life. We understand that being average lead to average results.
We see the data – front and center and act upon it with conviction. Buying cheap, unloved companies – wins. Buying Momentum – wins. Buying small little-discovered companies – wins.
We acknowledge our cognitive biases and fallacies, and we know our mind can trick us. We invest systematically, and we rely on facts, not stories.
Investing legend, Walter Schloss once said: “It takes a decade until you start to know what you’re doing (in investing, T.D.).” I couldn’t agree more. It a lifelong journey of learning, and experience, yet an exciting and rewarding one.