Schools of Thought

Here , we will cover three battles over how to invest. These back-and-forth arguments have persisted for years in the investing world. These are not the only sources of contention, but they are three of the bigger ones.

1)   Active Investing vs. Passive Investing--Active investors try to perform better than the market, whether due to manager skill or superior methodology. Passive investors try to merely mimic the results of the broad indexes, such as the S&P 500 or the NASDAQ. Passive investors are right that active management normally fails to deliver thanks to hard-to-justify fees and manager underperformance. Active investors rightly claim the argument almost boils down to semantics, as even passive management requires active decisions on how to best divide up the investments, as there are many indexes.

2)   Fundamental Analysis vs. Technical Analysis--Fundamental analysis is based on the financial situation of the underlying company. This type of analysis relies on balance sheets, income statements and various other accounting and financial reports. Technical analysis relies on information based on only price and volume, normally in the form of charts and graphs.

3)   Discretionary vs. Mechanical--Discretionary investing involves decisions based on the manager’s judgement and read of a situation. Mechanical investing follows specific rules and removes real-time decision making and emotion. For example, if x happens, do y.

Part of the problem is that these elements are not mutually exclusive and can be mixed and matched. There can be discretionary active investing based on fundamental analysis, mechanical active trading based on technical analysis, etc.

What the Data Shows

There is no shortage of opinions on how invest. A variety of methods have worked for a variety of people, the key is figuring out which methods are robust, replicable and suit your personality. “Robust” and “replicable” methods can function in multiple environments/time frames and can be done by anyone following the formula. While we won’t presume to be able to present an exhaustive list of viable investing methods, below are three broad methods that tend to work when you carefully follow a well-developed plan.

[Note: one more thing to keep in mind before dissecting data is to avoid curve-fitting or optimizing. This means  “torturing” data to fit a theory that is not likely to succeed in future time periods. For instance, someone could look back at market returns and notice that tech and retail stocks starting with vowels perform well between Labor Day and Columbus Day. While this might be generally true about the past, there is no good economic (or behavioral) reason for this and investing according to this method is unlikely to be successful going forward as any past outperformance is probably based on coincidence.]

1)    Passive Indexing/Asset Allocation--This involves investing in a broad index (or a group of them) and leaving the money alone, but for occasionally rebalancing, either once a year or when the values deviate too far from their original amounts. A well-known example of this is the 60/40 portfolio. Sixty percent of the money is invested in a  fund that tracks the performance of an index such as the S&P 500. The rest is invested in a bond-based fund. As the assets change in value, the portfolio will deviate from 60/40 and so, must be rebalanced periodically, about once a year is generally sufficient. This is only one of many examples. The beauty of this system is that there is evidence that the makeup of the portfolio can vary greatly. What matters more is sticking to your plan through good times and bad, as there as certain to be periods of underperformance and frustration.

2)    Momentum/Trend following--This is buying assets that have performed well in the recent past, or, in other words, sticking with the hot hand. Some people think of momentum and trend following as the same, some people think of them as cousins, and some people think of them as really  distant cousins. Another good, but imperfect, connotation is that momentum is used on stocks, and trend following is used on futures. This article points out that momentum compares an asset to other assets  while trend following only looks at the asset's own performance.

While these differences matter, they are again, beyond the scope of this post. The important things to remember here are that, when done correctly, the data shows that momentum and trend following tend to work and there is evidence that assets that perform well in the recent past (up to a year) tend to perform better in the near future.Also, keep in mind that for momentum/trend following, it’s vital to have a strict set of rules for buying and selling. Using momentum combined with gut-level predictions is likely to end badly. Also, it needs to be applied to a broad basket of stocks and commodities. It is also important to remember that different strategies work on futures and stocks. This book by Andreas Clenow is likely the best thing I have found on that matter. He does a good job making the complex interesting, but it is for the serious investor.

3)    Value--This involves the buying of assets perceived to be trading less than their intrinsic worth (though there is debate as to what defines "intrinsic worth"). It is the associated with investors such as Benjamin Graham and Warren Buffet. While data and backtests by a lot of different sources give credence to the idea that value investing works, it also involves a good deal of data-mining and complexity, as opposed to the relative simplicity of momentum and trend following. This is because trend-based metrics boil just about everything down to price, whereas value involves more accounting reports and company valuations. Also, drawdowns (declines) can be as large, or larger, than buy and hold investing.


For further research:

Website on asset allocation/indexing:

Website on asset allocation/momentum:

Trend following book: The Complete Turtle Trader by Michael Covel

Asset allocation book: The Intelligent Asset Allocator by William Bernstein

Momentum book: Dual Momentum by Gary Antonacci

Value Investing book: Quantitave Value by Wes Gray and Tobias Carlisle (Haven’t read this one all the way through. Not for the faint of heart.)

Asset Allocation book: Permanent Portfolio called The Permanent Portfolio: Harry Browne’s Long Term Investment Strategy by Craig Rowland and J.M. Lawson