Process over Short-Term Outcome

Jim O’Shaughnessey, author of What Works on Wall Street, recently wrote about 7 traits that he believes are required for active investors to win in the long run.  I fully agree with all 7, but I found #2 on his list to be particularly compelling:

2. Successful Active Investors Value Process over Outcome.

“If you can’t describe what you are doing as a process, you don’t know what you’re doing.”

~W. Edwards Deming
The vast majority of investors make investment choices based upon the past performance of a manager or investment strategy. So much so that SEC Rule 156 requires all money managers to include the disclosure that “past performance is not indicative of future results.” It’s ubiquitous–and routinely ignored by both managers and their clients. In keeping with human nature, we just can’t help ourselves when confronted with great or lousy recent performance. “What’s his/her track record?” is probably investors’ most frequently asked question when considering a fund or investment strategy. And, as mentioned above, the vast majority of investors are most concerned with how an investment did over the last one- or three-year period.

Yet successful active investors go further and ask “what’s his or her process in making investment decisions?”  Outcomes are important, but it’s much more important to study and understand the underlying process that led to the outcome, be it good or bad. If you only focus on outcomes, you have no idea if the process that generated it is superior or inferior. This leads to performance chasing and relying far too much on recent outcomes to be of any practical use.  Indeed, shorter-term performance can be positively misleading.

Look at a simple and intuitive strategy of buying the 50 stocks with the best annual sales gains. Consider this not in the abstract, but in the context of what had happened in the previous five years:

Year                            Annual Return            S&P 500 return

Year one                      7.90%                          16.48%

Year two                     32.20%                        12.45%

Year three                   -5.95%                         -10.06%

Year four                     107.37%                     23.98%

Year five                     20.37%                        11.06%


Average Annual

Return                         27.34%                        10.16%

$10,000 invested in the strategy grew to $33,482, dwarfing the same investment in the S&P 500, which grew to $16,220. The three-year return (which is the metric that almost all investors look at when deciding if they want to invest or not) was even more compelling, with the strategy returning an average annual return of 32.90% compared to just 7.39% for the S&P 500.

Also consider that these returns would not appear in a vacuum—if it was a mutual fund it would probably have a five star Morningstar rating, it would likely be featured in business news stories quite favorably and the long-term “proof” of the last five years would say that this intuitive strategy made a great deal of sense and therefore attract a lot of investors.

Here’s the catch—the returns are for the period from 1964 through 1968, when, much like the late 1990s, speculative stocks soared. Investors without access to the historical results for this investment strategy would not have the perspective that the long term outlook reveals, and thus might have been tempted to invest in this strategy right before it went on to crash and burn. As the data from What Works on Wall Street make plain, over the very long term, this is a horrible strategy that returns less than U.S. T-bills over the long-term.

Had an investor had access to long-term returns, he or she would have seen that buying stocks based just on their annual growth of sales was a horrible way to invest—the strategy returned just 3.88 percent per year between 1964 and 2009! $10,000 invested in the 50 stocks from All Stocks with the best annual sales growth grew to just $57,631 at the end of 2009, whereas the same $10,000 invested in U.S. T-Bills compounded at 5.57 percent per year, turning $10,0000 into $120,778. In contrast, if the investor had simply put the money in an index like the S&P 500, the $10,000 would have earned 9.46 percent per year, with the $10,000 growing to $639,144! What the investor would have missed during the phase of exciting performance for this strategy is that valuation matters, and it matters a lot. What investors missed was that these types of stocks usually are very expensive, and very expensive stocks rarely make good on the promise of their sky-high valuations.

Thus, when evaluating an underlying process, it’s important to decide if it makes sense. The best way to do that is to look at how the process has fared over long periods of time. This allows you to better estimate whether the short-term results are due to luck or skill. We like to look at strategies rolling base rates—this creates a “movie” as opposed to a “snapshot” of how strategies perform in a variety of market environments.

This is a philosophy you’ve repeatedly heard from us as well.  Short-term outcomes are important, but process ultimately determines long-term results.  Among the ways that this can be illustrated is by looking as some of our white papers on relative strength investing.  John Lewis’ white paper, Point and Figure Relative Strength Signals detailed the long-term investment results of a relative strength process that took 1,000 U.S. stocks and categorized them into one of four portfolios based on their PnF relative strength signal (BX-buy signal and in a column of X’s; BO–buy signal and in a column of O’s; SX—sell signal and in a column of X’s; or SO—sell signal and in a column of O’s).  Portfolios were equal-weighted and rebalanced on a monthly basis.  Performance of these four portfolios from 12/31/1989 to 12/31/2015 is shown below.  As detailed in the paper, following a disciplined process of investing in stocks with the highest momentum (BX portfolio) generated significant outperformance over this test period.

base rates

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Long-term success with active management comes from doing sufficient due diligence to either design a robust investment process yourself (or to employ one designed by someone else) and then to execute, execute, execute.  If the process is sound, long-term outcomes should take care of themselves.

The performance above is based on total return, inclusive of dividends, but does not include transaction costs.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Some performance information presented is the result of back-tested performance.  Back-tested performance is hypothetical and is provided for informational purposes to illustrate the effects of the strategy during a specific period. The hypothetical returns have been developed and tested by DWA, but have not been verified by any third party and are unaudited. Back-testing performance differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with the benefit of hindsight. Model performance data (both backtested and live) does not represent the impact of material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money.  Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

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