Systematic Relative Strength

The Wall Street Journal ran an interesting article a few months ago on uncertainty. It’s been sitting on my desk for a few months, percolating. (At least that’s my version of the story. It might less charitably be referred to as my archival heap.) The article, by the great Jonah Lehrer, was originally oriented toward the economic uncertainty that prevailed, possibly holding back the recovery.

I think it is just as applicable to everyday investment policy. Each time a transaction is made, there is uncertainty about the outcome—but it doesn’t always seem that way. The transactions that work out the way we expect seem, in retrospect, to have been obvious or inevitable. The application, I think, is to those transactions that result in losses.

Here’s the excerpt from the article that struck me:

Consider a 2006 study by the economists Uri Gneezy, John List and George Wu, in which people were asked how much they would pay for various items. One offering consisted of $50 and $100 Barnes & Noble gift certificates. Not surprisingly, subjects were willing to pay larger amounts for larger gift certificates: They offered, on average, $45 for the $100 gift certificate and $26.10 for the $50 one.

Everything changed, however, when the economists introduced a little uncertainty into the marketplace. Instead of bidding on guaranteed gift certificates, the subjects were offered lotteries in which they were sure to win one of the options but didn’t know which one. A sample lottery, for instance, gave the subjects a 50% chance of winning the $100 Barnes & Noble gift certificate and a 50% chance of winning the $50 one. If people were rational agents, they should have offered to pay between $26.10 and $45 for a chance to win. Instead, the subjects were willing to pay only $16. This is the curse of uncertainty. It makes every possibility seem less appealing.

I added the bold to emphasize what happens when emotions get involved. It’s what typically happens when an investor has a series of losses. Fear sets in and doing nothing seems like a good idea. Studies of purchased trading systems verify the diagnosis of paralysis. Even when systems are well-specified and tested, guess how many consecutive losses it takes to get most would-be traders to abandon the system? Three! Paralysis is not a good investment strategy—it prevents further losses, but completely prevents further opportunities as well.

The only antidote I know of to emotional paralysis is commitment to a systematic investment approach. If the method is robust, it will continue to adapt to the market environment and expose your portfolio to opportunities. It won’t panic and it won’t try to protect its ego. As the old saying goes, it may be right or wrong, but it is never in doubt. It just keeps grinding away on the tested return factor, which is much more likely to be profitable over the long run than paralysis.