The Parable of the Air Conditioner

January 26, 2010

We have problems with the HVAC system in our office building. Long story short, when it’s hot outside, the heater blows hot air, and when it’s cold outside, the A/C blows cold air. At first we joked about it in the office…what a funny coincidence! But after time, the bad timing begins to feel sinister, like someone in the control room is toying with us.

Here’s a simple chart I created showing the time of day, the temperature outside, and our HVAC activity according temperature level.

Time Outside Temp AC / Heat
6 AM Chilly AC
10 AM Mild AC
12 PM Warm Heat
2 PM Warm Heat
6 PM Chilly AC

As you can see, the HVAC system in our building is just plain wrong. Why do you care? Why does this matter?

It occurred to me that the HVAC system in our building has the same timing as a retail investor. Buy the peak and sell the valley. Fight hot air with hot, and cold air with cold. Our HVAC system and the retail investor share this important attribute: they are almost always wrong.

We like to use the DALBAR numbers to drive home the point that retail investors fail to time the market correctly. The most recent numbers show that retail investors lag the broad market by an average of 6.5% annually (read this article again). One word describes the phenomenon – BRUTAL!

The HVAC system in our office is like the typical retail investor, loading into the market at the top and then getting out near the bottom. Our systematic process removes the psychological pressure we feel as investors (emotion), by forcing us to manage our portfolios according to consistent, tested rules. With emotions taken out of the equation, we can filter through the short-term noise and focus on the long-term results.

P.S.– We are working on the investor behavior thing. The A/C is a lost cause.

Leave a Comment » | Investor Behavior, Thought Process | Permalink
Posted by JP Lee

New White Paper: DWAMM Testing Process

January 26, 2010

Anyone involved in developing and implementing systematic investment strategies should be obsessed with testing. There is no end to the advice you can find about how to invest. The problem for investors is that most of these investment ideas don’t actually stand up to rigorous testing. They may sound good, and they may have worked for a short time period, but when you test them over different market conditions they don’t work as advertised.

We focus on relative strength as the main (or only) factor in our investment process. There has been quite a bit of testing done over the years that shows how well RS/Momentum works over intermediate-term time horizons. There are certainly other factors that stand up to rigorous testing over time, but RS is where we feel we have an exploitable edge over time. Market technicians have used RS/Momentum for many years. The development of computers in the 1960′s even allowed large-scale testing of the idea that strong stocks outperform over intermediate-term time horizons. The academic community got into the act in the early 1990′s, and have continued to research the topic heavily because it was such a blow to long-held academic theories about stock market behavior. With so many different people testing RS using different universes and different formulations for calculating RS, I think it’s safe to say that RS/Momentum strategies can add alpha over time.

What is frustrating about most of this testing is that is very difficult to implement in an actual portfolio. Do you really want to go long 200 stocks and short 200 stocks and rebalance the whole portfolio every month? Not likely. So in the real world, portfolio managers take a factor that has been proven to work, and then begin haphazardly applying it to their style. Is it a sound investment strategy to take a list of high RS stocks and then buy a subset that have “good managements?” Will it work if you cherry pick some stocks with good value characteristics out of the high RS list? What if you don’t rebalance on the same schedule as the RS testing? These are just some of the problems if you don’t implement your strategy exactly as the research was done.

We designed a custom testing process here that determines how robust RS/Momentum is as a factor. Instead of rebalancing each month, quarter, or year we run a continuous process that behaves like an actual portfolio manager would. We also run a Monte Carlo process that buys high RS stocks at random instead of just taking the top ranked stock. This helps us determine what kind of range in outcomes we can expect over time, and what can happen if you get lucky or unlucky in your stockpicking.

In a whitepaper available here we outline our unique testing process using several well-known RS factors. We have a proprietary RS factor we use for our actual portfolio management, but we used well-known factors because people are always amazed that it doesn’t take a “silver bullet” to outperform over time using RS.

1 Comment | Relative Strength Research | Permalink
Posted by John Lewis

Relative Strength Spread

January 26, 2010

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks). When the chart is rising, relative strength leaders are performing better than relative strength laggards. As of 1/25/2010:

As with all strategies, certain environments are more favorable than others for relative strength. We’ve seen a little of everything over the last three years. The RS Spread enjoyed a fairly stable trend higher in 2007. From July of 2008 to March of 2009 the RS Spread gyrated between very favorable and very unfavorable environments. From March 2009 to to May 2009 the RS Spread plunged as the laggards rocketed higher. Since then, the RS Spread has languished.

What comes next? The historical precedent is for a period of a declining RS Spread to transition into a much more favorable environment for relative strength. Time will tell how soon this transition takes place.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer