Two Problems Investors Don’t Realize They Have

April 13, 2011

Carl Richards from the brilliant has an apt illustration of a common, and disappointing, occurrence for many investors.  It’s kind of funny because it’s true, but the disillusionment can turn a lot of people off to the markets:

The outcome is unpleasant and the outcome is what most investors focus on.  But focusing on the outcome masks two common problems that investors don’t realize they have.

1) Despite the implication of the cool graphic, the cause of the investment problem is not buying what is hot.  The actual problem is the lack of an appropriate investment process—what to do when the asset is no longer hot, for example.

2) The second common confusion centers around holding an asset with current lousy performance and holding a strategy with current lousy performance.  Those two things are worlds apart.

Because many investors do not distinguish between these problems, they wind up avoiding situations and strategies that could be quite profitable, if only they knew how to handle them correctly.  In effect, they end up like the cat in Mark Twain’s parable:

The cat, having sat upon a hot stove lid, will not sit upon a hot stove lid again. But he won’t sit upon a cold stove lid, either.

Learning from mistakes is important, no doubt about it.  But if you learn the wrong thing from that mistake, you’ll make that same mistake again—because you won’t recognize it as the same mistake.  It’s the difference between having 25 years of experience or one year of experience 25 times.

Investment process is much, much more important than most investors realize.  If you look primarily at past performance, you’re just seeing what happened.  The important thing is to dig in to the investment process to understand why it happened.  Was it luck or was there a consistent process at work?  Can the success be replicated, or was it dependent on the current (and perhaps unusual) market environment.  Is the investment process designed to get maximum benefit from a given return factor?

Let’s look at a practical example along the lines of the napkin.  What is strong currently?  Well, stocks like AAPL and PCLN, sectors like semiconductors and oil service, commodities like silver and gasoline, asset classes like REITs or domestic small caps, or countries like Russia and Thailand.  It should be apparent that buying what is strong can mean a lot of different things.  It should also be apparent that buying into any of these securities isn’t, in itself, the problem.  Every security or asset class will go out of favor at some point.  If your investment process is designed to adapt, there is really no issue.  If Thailand begins to weaken, you would simply replace it with, say, Sweden.

Although I’ve described a rotational relative strength process above, the same thing is true of a value-oriented investment process.  You would start by purchasing securities that rank highly for valuation, regardless of what metric you chose—but you can’t stop there.  If you have a robust investment process, you will also have a defined methodology for trimming securities as they become overvalued based on your metric, as well as culling value traps (losers that turned out to be cheap for a good reason!) from the portfolio.

Different return factors might require different methods to maximize their results, but if the return factor is to be used in real life, there had better be some systematic way of implementing it!  Investors spend far too much time looking at the return instead of lifting the hood and trying to understand the actual investment process.  The current results are largely irrelevant—anyone can get lucky for a short time—unless you can understand how those results were generated.

There’s also a world of difference between an asset and a strategy.  Let’s say you have found a successful investment strategy and that you understand how it works.  If you look back at how it has performed historically, you will notice that it will perform better in some environments than others.  All strategies will go through periods of outperformance and underperformance.  For example, sometimes value managers do very well against the market; their performance can be miserable at other times.  Yet regardless of their current performance, they are still buying stocks that rank highly on their value metric.  They are engaged in the exact same process year-in and year-out.  It’s only their end results that vary from period to period.  Understanding the difference is critical.

If you buy an individual asset and it goes south, it might be prudent to dump it.  You have no assurance that it will ever return to favor.  It might be a top-notch semiconductor fabricator down temporarily because of the business cycle, but it could also be a top-notch manufacturer of horse-drawn carriages that will stay down for the count.  A strategy is somewhat different.  If you abandon a previously successful relative strength or value strategy, you are essentially betting that relative strength or value will never work again.  That’s a much tougher bet to win. Yet retail investors make that bet—and lose it—all the time.  In fact, Morningstar demonstrates that it is possible to outperform just by betting on the strategies that retail investors have recently abandoned!

“Stay the course” is advice that needs to be interpreted very selectively.  It makes eminent sense to stay the course with a strategy, but with an individual asset you probably do want to get out of Dodge as soon as it goes south.

If you can learn to focus on process rather than current results, and can differentiate between an asset and a strategy, you are likely to have an enormous improvement in your investment results.

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Back to the Future?

April 13, 2011

Jim O’Shaughnessy’s April 2011 market commentary provides an interesting analysis of the real returns to stocks and bonds during different inflation environments.  Of particular interest to relative strength investors is his analysis of the performance of high momentum stocks.  As shown in the table below, the stocks with the highest 6-month price momentum outperformed the benchmark in each of the inflation regimes during the observation period of 1926-2010.

(Click to Enlarge)

Some may look at the  government statistics today and argue that inflation is not currently an issue.  However, it is well documented that the United States government has revised its method of calculating inflation several times over the years, which has had the effect of understating inflation.  According to Shadow Stats, if the government measured inflation on its pre-1982 methods, it would be running at 11.6% percent right now, or 7.3% using the pre-1998 calculations.  In other words, we are arguably already in a period of high or severely high inflation.

O’Shaughnessy covers the performance of high momentum stocks during the last regime of severely high inflation (1973-1980):

As the upcoming Fourth Edition of What Works on Wall Street documents, the ten percent of stocks from our All Stocks universe with the highest six-month price appreciation earned a real (inflation-adjusted) average annual compound return of 15.66 percent, turning $10,000 invested on December 31, 1973 into $27,691 at the end of 1980.

Different inflation regimes provide headwinds for some companies and industries and tailwinds for others.  The goal of relative strength strategies is to let relative price performance tell us which companies have the wind at their backs and are producing the best performance in the current environment.  History suggests that relative strength strategies tend to do just fine in high inflationary environments.

Past performance is no guarantee of future returns.

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High RS Diffusion Index

April 13, 2011

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 4/12/11.

The 10-day moving average of this indicator is 83% and the one-day reading has pulled back to 55%.


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