Systematic Relative Strength

Joel Greenblatt of Gotham Asset Management is well-known for his Magic Formula investing approach. He wrote a recent commentary that appeared on Morningstar about his experience offering his methodology to retail investors over the last two years. He writes:

Wow. I recently finished examining the first two years of returns for our Formula Investing U.S. separately managed accounts. The results are stunning. But probably not for the reasons you’re thinking. Let me explain.

Formula Investing provides two choices for retail clients to invest in U.S. stocks, either through what we call a “self-managed” account or through a “professionally managed” account. A self-managed account allows clients to make a number of their own choices about which top ranked stocks to buy or sell and when to make these trades. Professionally managed accounts follow a systematic process that buys and sells top ranked stocks with trades scheduled at predetermined intervals. During the two year period under study[1], both account types chose from the same list of top ranked stocks based on the formulas described in The Little Book that Beats the Market.

Let’s put it another way: on average the people who “self-managed” their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some!

Mr. Greenblatt analyzed the data and explains exactly how it happened. Consider these the four deadly sins.

1. Self-managed investors avoided buying many of the biggest winners.

2. Many self-managed investors changed their game plan after the strategy underperformed for a period of time.

3. Many self-managed investors changed their game plan after the market and their self-managed portfolio declined (regardless of whether the self-managed strategy was outperforming or underperforming a declining market).

4. Many self-managed investors bought more AFTER good periods of performance.

I didn’t even have to add the bold type—Mr. Greenblatt did it for me. He has useful discussions about why each of these things happen, but this is absolutely typical investor behavior, stuff we have written about over and over again. Investors on their own, I suspect, could figure out a way to perform poorly even if they had tomorrow’s Wall Street Journal. Implied in Greenblatt’s commentary is a strong argument in favor of hiring a disciplined and systematic investment advisor.

Think about this: all of the excess return that typical investors are giving away is available to investors who are 1) willing to implement a strategy even when it is uncomfortable, 2) willing to stick with a solid long-term investment strategy, and 3) add money during periods of weakness. If your advisor is willing to do that, they are probably worth every penny.

This entry was posted on Monday, February 6th, 2012 at 9:27 am and is filed under From the MM, Investor Behavior, 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.