Systematic Relative Strength

It’s well known in behavioral finance that investors experience a loss 2-3x more intensely than a gain of the same magnitude. This loss aversion leads investors to avoid even rational bets, according to a Reuters story on a recent study by a Cal Tech scientist.

Laboratory and field evidence suggests that people often avoid risks with losses even when they might earn a substantially larger gain, a behavioral preference termed ‘loss aversion’,” they wrote.

For instance, people will avoid gambles in which they are equally likely to either lose $10 or win $15, even though the expected value of the gamble is positive ($2.50).

The study indicates that people show fear at even the prospect of a loss. Markets are designed to generate fear, not to mention all of the bearish commentators on CNBC. Fear leads to poor decisions, like selling near the bottom of a correction. Unless you are planning to electrically lesion your amygdala, the fear is going to be there-so what’s the best way to deal with it?

The course we have chosen is to make our investment models systematic. That means the decisions are rules-based, not subject to whatever fear the portfolio managers may be experiencing at any given time. Once in a blue moon, excessive caution pays off, but studies suggest that more errors are made being excessively cautious than overly aggressive. A rules-based method treats risk in a even-handed, mathematical way. In other words, take risks that historically are likely to pay off, and keep taking them regardless of your emotional state. Given enough time, the math is likely to swing things in your favor.

According to a fascinating study discussed in Time Magazine based on 27 million hands of Texas Hold’em, it turns out that the more hands poker players win, the more money they lose! What’s going on here?

I suspect it has to do with investor preferences-gamblers often think the same way. Most people like to have a high percentage of winning trades; they are less happy with a lower percentage of winning trades, even if the occasional winner is a big one. In other words, investors will often prefer a system with 65% winning trades over a system with 45% winning trades, even if the latter method results in much greater overall profits.

People overweigh their frequent small gains vis-à-vis occasional large losses,” Siler says.

In fact, you are generally best off if you cut your losses and let your winners run. This is the way that systematic trend following tends to work. Often this results in a few large trades (the 20% in the 80/20 rule) making up a large part of your profits. Poker players and amateur investors obviously tend to work the other way, preferring lots of small profits-which all tend to be wiped away by a few large losses. Taking lots of small profits is the psychological path of least resistance, but the easy way is the wrong way in this case.