In the investment world lately, there had been a fair amount of positive press about Odds On: The Making of an Evidenced-Based Investor by Matt Hall. There were a lot of 5-star reviews on Amazon, and they were so quick and positive that I couldn't help but wonder if this was an orchestrated campaign or sincere praise.
The book basically focuses on Hall's journey from being a broker trainee at a firm only focused on their own profits (and relying only on their half-assed guesses) to finding success as an adviser by focusing on the client’s needs and what really works in investing. Admittedly, I found the book a bit flimsy… at first. But, it’s really a memoir more than a how-to book, so I gave it some grace. The long and short of it is this: investors are best served by focusing on buying and holding a broad array of asset classes (x% in U.S. stocks, y% in bonds, y% in foreign stocks, etc.) as opposed to trying to get lucky by predicting the market’s next move. This approach basically gives up any hope of beating the market, but it tends to work a lot better than the gut-level approach-a fool’s errand that almost ends in poor returns. This approach, also known as “indexing” or “asset allocation”, is based on the theory of Efficient Market Hypothesis, which basically says that market prices reflect all available information, so trying to beat the market is unlikely to succeed.
Hall eventually finds his place at Buckingham Asset Management, an evidence-based (data driven) firm whose chief researcher and dragon-slayer is well-known author Larry Swedroe. Swedroe has had a lot of success in investing and favors the “shock and awe” approach as a way of divesting people of their pre-conceived notions. So, Swedroe clearly on a crusade, as by this time in his life, he had already made a lot of money and didn’t need any more. After 5 or 6 years, Hall leaves BAM with fellow employee Rick Hill to start the Hill Investment Group in 2005. Happily, they leave on very friendly terms and the two entities (Hill and BAM) continue to have a business relationship to this day. As he attempts to build his business, a lot of Hall’s efforts involve trying overwhelm prospects with information, albeit in a slightly more diplomatic manner than his former mentor, Swedroe. This involves a lot of data and attempts to painstakingly answer all client questions and concerns.
Hall encounters resistance, but the business slowly grows, thanks in large part to Rick Hill (who is a lot older and more established) bringing a substantial book of business to the table. Things change, however, when Hall gets sick (the fact that the story contains and “Hall” and a “Hill” doesn’t make this easy). He loses his energy, feels awful and after a lot of searching, finds out he has leukemia. He gets an appointment with an expert, and in the weeks leading up to the meeting, drives himself mad with possibilities and what-ifs. At the meeting, though, his doctor basically says, “I hear your concerns, but the best course of action is to take this drug called Gleevec, put your concerns on the shelf and live your life”. Gleevec isn’t 100% effective (or at least it wasn’t at this point), but it gave Hall the best odds of survival and worrying about the chance of failure wasn’t going to help and might even hurt his chances of beating the disease.
Long story short, Hill shuts up, trusts the expert (and just as important, trusts the data), takes the drug and the disease goes into remission. As this happens, he begins to think about how this approach applies to his work. What if he spent less effort trying to answer all client questions and alleviate all concerns and instead just said, “Look, I hear you, but, based on the data this approach gives you the best chance for success and quality of life”? In short, it’s no guarantee of success, but such a guarantee doesn’t exist anyway and this beats the alternative of buy and hope.
So, at the end of the day, it’s a good, compact read. But, it got me thinking about what truly works in investing. Clearly, Hill’s approach has a lot of merit, but his method is one of a few statistically robust approaches. When it comes to investing, the data supports this: asset allocation, momentum and value. And while the book does concentrate on the asset allocation/indexing end of things, it does give a nod at the end to the fact that data supports momentum and value, as well. Let’s look at each.
Asset Allocation-As seen previously, this involves dividing up your assets over a variety of broad indexes (S & P 500, Russell 2000, government bonds, etc.). The exact percentage would vary based on age and risk tolerance. Your account value will go up and down (and sometimes be cut by 50%, as in 2007-2009). The good news is that the market has always bounced back and dollar cost averaging (investing a fixed amount each month) tends to result in opportunistic buying-when the market goes down, you mindlessly buy more shares because prices are cheaper, which helps when the market recovers.
So, what’s the catch? Well, lots of people are buy and hold investors…until they aren’t. The market takes a dive and they start asking existential questions about what really works, sell at or near the bottom and jump back in long after the recovery has begun. We’ve seen two 50%+ declines in the market in the last 16 years-it’s likely to happen again. Hanging on was bad enough during the last two recoveries, which were pretty quick. How would you fare during the Great Depression, when it took about 15 years to get back to even? In light of current government spending and total US debt, it would be foolish to dismiss the possibility of such a once-a-century decline. It would also be foolish to bet heavily against the US economy. The end of the world has been coming for about 30 years and, yet, here we are.
So, there’s the rub. This approach takes faith and consistency. If you can’t handle the dizzying highs and lows, the choices are to 1) find a conservative asset allocation that has a relatively smooth ride or 2) find another approach. As a final word consider this: the exact mix of assetsdoesn’t matter all that much when it comes to return (although some approach get you to the same place with a lot less stress than others).
Momentum- There are a few ways to apply momentum (also called “trend following”, although seem people think there is a slight distinction between the two-we will ignore that for now), but it comes down to this: sticking with the hot hand. Also, successfully applying momentum requires discipline, just as asset allocation does. It’s not merely buying what looks hot and has been on the cover of Smart Money. It requires a specific set of criteria for buying and selling decisions. And the data shows it works. Momentum has been called one of the persistent anomalies by none other than Eugene Fama, a lion of the efficient markets hypothesis-a theory generally at odds with momentum. By “persistent anomaly”, Fama basically means it is something that has worked in the past as a viable strategy and seems likely to continue, based on the best data available, assuming it is applied correctly and diligently. One of the main benefits of it is that it basically boils down to one thing: price. No pouring over balance sheets and cash flow statements or relying on the advice of analyst’s buy/sell recommendations when they may or may not being peddling garbage. So, in short, the data is so solid on momentum that even people who don’t like it have to recognize that fact.
When done correctly, momentum can reduce drawdowns (declines) by half and can provide a few extra percentage points of return per year. However, while I believe market outperformance is possible, any adviser selling based solely on it is dancing in dangerous territory, especially if advisory fees are involved (the fees can really eat into the outperformance quickly). Additionally, any system is going to see periods of underperformance relative to the market. This especially true in bull markets. Because of the buying and selling rules, momentum strategies aren’t going to capture all of an upswing or a downturn. So, during market comebacks like the one we have seen over the last 6-7 years, it’s likely that a momentum strategy would perform worse than a dartboard and a clown. It’s generally during the downturns that these methods justify their existence, as they tend to stay in cash while everything else goes down in value. During the bull markets, everyone thinks they are a genius and that they don’t need a methodology (or an adviser).
Also, it’s not just about the ups and downs. Markets have choppy periods when they don’t trend either way. During these periods, it is common to get “whipsawed”, which means a series of trades in and out of positions. These can result in poor performance, gray hairs, gnashing of teeth, and, tragically, abandonment of the strategy. The true uptrends and downtrends are easy compared to the false alarms that such a system can generate.
But, I think the best mindset for momentum is just to look at it as a way of smoothing out returns. If it gives you a strategy that has a reasonable chance of avoiding deep declines and that you can stick with, it has done its job. Outperforming the market is gravy, just don't pay too much for the hope of outperformance.
Value-Made famous by such investors and Benjamin Graham and Warren Buffett, value investing is simply investing in companies that have been beaten down by the market. Like momentum, the value anomaly is so pervasive that it is generally recognized by the proponents of the efficient markets hypothesis, even though they wish it weren’t true. The “value premium” exists, in that much academic literature has validated the idea that value stocks outperform “growth” (think “non-value”) stocks. As to a formal definition of what the value premium is, this works.
So, value investing is viable. It has downsides though. One of the problems with this is that, unlike momentum, price alone isn’t a sufficient indicator. A stock trading at 10 that used to be worth 20 isn’t a bargain if it is really worth 5 (and headed that direction). You need to a set of criteria that can get rather involved, as opposed to merely compared today’s price to a previous higher price. The book Quantitative Value is a good place to start, but a word of warning: even I got bored reading it. And while the authors can run circles around me in terms of statistics and data, the set of investing criteria was so large and expansive that I couldn’t help but fear that they were “curve-fitting” the data. This is basically applying a complicated set of rules that reflect the past but won’t hold up in the future. Could I be wrong? Of course, but any time the investment rules are complex, this is a risk.
Another issue with value investing is that, while returns can beat the market, the ride to get them could be just as bumpy as that of the market as a whole. So, the road to be the next Warren Buffett is littered with dead bodies for a reason.
In closing, there are some caveats here:
- This doesn’t cover every type of investing. Closely-held real estate, small businesses and other non-liquid investments don’t follow the same rules. Stock and bonds follow these rules because there are transparent (mostly), liquid markets for them. Private, thinly traded stocks and bonds and similar investments are a different game, as is a business that you are directly involved with and can control.
- I wouldn’t say the three methods outlined above are the only ways to invest. I am the first one to admit that I don’t know what I don’t know. Companies are making a killing doing high-frequency trading (a whole other game with a high cost of entry) and there is a ton of work being doing in the fields of artificial intelligence and neural networks. But that is cutting edge and also would likely have a high cost of entry. Furthermore, lots of methods tend to work for a while, but their advantages get exploited by the market and disappear. That is one of the fundamental problems with value investing. While it still can work, the market environment is fundamentally different than when Warren Buffett got started. It is more dependent on information than momentum or asset allocation and therefore, the recent democratization of data has made it a trickier playing field. That being said, value still has a place, so the three methods outlined here are just the ones with what I believe is the best data.
- Some people have had really good results with old school stock picking and predictions. I can’t argue with anyone’s experiences, but anyone making such claims must realize that their results aren’t the norm and replicating such results is difficult, if not virtually impossible. Say what you will about asset allocation, momentum and disciplined value, they can be replicated to one degree or another (again, value is the diciest).
- Knowing yourself is the ultimate form of aggression. Don’t pick a method that you will abandon when it hits the fan. And even when you do pick a plan that you think you can stick with, you won’t really know how much conviction you have until it is tested. As the great felon/philosopher Mike Tyson said, “Everyone has a plan until they get punched in the mouth”. If you feel the need to gamble with gut-level predictions and can’t help yourself, set aside a small percentage of your money for that and have a more diligent plan for the rest of your money. Just recognize it for what it is: speculation.
So there you have it. It isn't just about what does work, it's also about eliminating what doesn't work: guessing, predictions and emotion.