Systematic Relative Strength

Here is the naked truth: capital markets are designed to reallocate money from dumb people to smart people. If that weren’t true, smart people wouldn’t play. Smart people don’t play unless they have a probability of winning. For example, smart people don’t tend to play the lottery. (If you have ever wondered why the PowerBall winner is always a nitwit and flat broke again in three years, now you know.) This might be the real reason that the rich continue to get richer. I have a high degree of conviction that if one took all of the money in the world and split it equally among all of its inhabitants, ten years later the people who have the money now would be likely to have the money again, simply because they understand what it takes to be successful in capital markets. Although I wrote the first sentence of this article for shock value, the naked truth is actually quite comforting.

Now, when I use the word “smart,” in the context of capital markets, I’m not talking about IQ at all. You don’t have to be a university professor or have an extensive financial background to be smart. In fact, it’s even possible those things could work against you. Rather, being smart about the capital markets requires a very specific skill set consisting of three things.

1) Knowledge. Smart means understanding which return factors are likely to outperform over time. If you plow through all of the investment literature as we have, you will see that it largely boils down to two return factors: relative strength and value. Both are robust and work in numerous formulations. Although we use a proprietary relative strength factor, there’s no one formulation that is magic. Success is mainly a matter of consistently exposing the portfolio to the return factor. Pick one-or both-because they complement one another extremely well. If you have just this small nugget of knowledge, you are miles ahead of the game.

2) Discipline. Smart means understanding that execution is more important than knowledge. It’s not enough to have the knowledge of which return factors will likely work over time. You need to have a systematic method of exposing the portfolio to your chosen return factor in a disciplined fashion. You cannot waver or let your emotions get in the way-and believe me, your fear will try to run you into the ditch during every correction. Maintain your emotional balance. You must remain resolute up to and including the end-of-the-world scenario. Maybe the world will end and I will be wrong about all of this. Probably not. If you consistently expose your investment capital to a good return factor in a disciplined way, you are light years ahead of your competition.

3) Patience. Smart means understanding that great patience is required. Most investors, I suppose, would like to get rich quick. That’s unlikely to happen. In a karmic kind of way, the universe actually makes you earn your money by going through trials and tribulations. The E-ticket ride you get in capital markets is never easy, and often not pleasant. Both relative strength and value go in and out of favor as return factors, sometimes slipping into eclipse for years at a time. Great investors are enveloped with a kind of Zen-like calmness. They are neither their profits nor their losses. You can’t take giddy mental ownership of your equity high-water mark or despair at your drawdown during a correction. Stay centered and let compounding work its magic. The journey of a thousand miles really does begin with a single step, but don’t forget that it also takes a long, long time to walk a thousand miles!

Investors with a small kernel of knowledge and oodles of discipline and patience are likely to see money flow their way over time-that’s how capital markets are designed to work. As you can see, “smart” relates much more to temperament than IQ. I would go so far as to say the temperament piece is probably the most important. While most investors engage in dumb behaviors like jumping from questionable method to method, adding money when they feel good about their results, pulling money out when they are temporarily panicked, measuring results over a short period of time, hiring and firing managers like a revolving door, and generally running about like a chicken with its head cut off, smart investors pursue reliable return factors with discipline and immense patience. If you take the perspective that the market is designed to take your money when you do something dumb, investors would be well-advised to think about their behavior carefully before every portfolio change.

This entry was posted on Wednesday, May 5th, 2010 at 1:19 am and is filed under From the MM, Markets, Non-partisan op-ed, Thought Process. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.