Systematic Relative Strength

Intuition can be a very helpful guide to decision-making in many areas, but it turns out to be a detriment in finance. Vanessa Drucker reviews David Adler’s new book Snap Judgement and paraphrases Mr. Adler’s suggested approach as “if you want to make money, stick to a steely discipline, and override your emotions.”

This is the entire thought process behind our family of Systematic Relative Strength portfolios: identify a factor with a strong record of outperformance and continue to pound stocks with high factor rankings into the portfolio. Not every transaction will work, of course, but over time exposure to the factor—in our case, relative strength–should lead to strong results.

We frequently get phone calls—and by frequently, I mean almost every day—from clients telling us that we could have improved our performance last quarter if we had only done thus and such, which always represents some form of temporary deviation from our disciplined approach. And very often, in that one particular case, the caller is correct. However, each one of these calls misses the larger point: how do you know when to deviate and when to switch back to a tested approach that has delivered good results over time? (Not to mention that our hindsight is 20-20 also.) Studies of systematic processes show that things are made worse by attempts to apply one’s “expertise” to the process. We applied our expertise at the front end of the process, when we built it. We believe in continuous improvement, so we are always examining ways to tweak it, but changes have to be based on data and results, not emotions and hindsight.

Mr. Adler is the not first writer on behavioral finance to say this, and I am sure he will not be the last. One can only hope that the public will eventually heed the message.

—-this article was originally published July 29, 2009. Discipline still wins. Of course it is always most difficult when negative emotions are running high.