Systematic Relative Strength

I suspect that many of us find it entertaining to listen to colorful tales of investment managers who comb the world for uncovered pieces of information that have not been fully priced into the financial markets. These clever investors then reap enormous profits as the market comes around to their way of thinking. Surely, many of us also feel sorrowful as we listen to the stories of investment managers who rack up enormous losses while sitting in positions only to find out that the market never comes around to their way of thinking….oh wait, the latter version of the stories are never told are they! The losing managers are never paraded around CNBC to tell their sorry story; that is the role reserved for the seers of finance who just might give us insight into what will come next. Because of this one-sided coverage, investors can be led to believe that the key to outsized returns is to “know something that others don’t.”

We have chosen a different path. We are aware of the potentially disastrous effects of overconfidence in the financial markets. What if our insight turns out to be flat out wrong? How long should we stay with such a position? Furthermore, we have great respect for the financial market’s ability to weigh all the evidence and for the supply and demand relationship to render a judgement about the direction of given trend. We are also aware of the potential to generate superior performance by implementing a systematic trend-following approach to investing.

Karl E. Weick and Kathleen M. Sutcliffe have written an excellent book, Managing the Unexpected, about why some organizations perform so much better than others. According to them, a key to good performance over time is to minimize the tendency to always seek confirming evidence for our current positions:

Many of your expectations are reasonably accurate. They tend to be confirmed, partly because they are based on your experience and partly because you correct those that have negative consequences. The tricky part is that all of us tend to be awfully generous in what we accept as evidence that our expectations are confirmed. Furthermore, we actively seek out evidence that confirms our expectations and avoid evidence that disconfirms them. For example, if you expect that Navy aviators are brash, you’ll tend to do a biased search for indications of brashness whenever you spot an aviator. Your’re less likely to do a more balanced search in which you weigh all the evidence and look just as closely for disconfirming evidence in the form of aviator behavior that is tentative and modest. This biased search sets at least two problems in motion. First, you overlook accumulating evidence that events are not developing as you thought they would. Second, you tend to overestimate the validity of your expectations. Both tendencies become even stronger if you are under pressure. As pressure increases, people are more likely to search for confirming information and ignore information that is inconsistent with their expectations.

From our perspective, a key to our long-term success is to remove the element of emotion from the investment process. Sure, we have strong emotions about what is going on in the financial markets just like everyone else. However, our emotions or our perceived insight into uncovered value will never be the impetus for any of our buys or sells. We will always defer to the market to tell us when it is time to move in or to move on.