John Maynard Keynes is famous for the following quote (via Wikiquote):
When the facts change, I change my mind. What do you do, sir?
When the following quote may be better suited to the challenge of investing:
There is no harm in being sometimes wrong — especially if one is promptly found out.
Today’s post at The Psy-Fi Blog entitled “Losing Momentum: Is It Time to Exploit Mean Reversion?” looks at the topic of investment strategies going in and mostly out of favor. The post looks at some recent research calling into question the momentum and small cap effects. The point being that both effects have shown themselves to be somewhat mortal. The underlying point of the post however is far more general than the fate of any specific effect. As I read it here is the crux of the matter:
Yesterday’s sure-fire winner is tomorrow’s dead-beat loser. That’s the fun thing about research into markets – you’re never quite sure if you’re measuring eternal market fundamentals or transient human behavior. It’s probably best to assume nothing works for ever.
This is the enduring dilemma for investors. Every strategy, whether it is in theory and/or in practice, sound or not goes through periods of underperformance. Strategies built on data mining or no time-dependent results will fall away and never come back. (However the popularizers of those strategies often make enough of a name for themselves so that this doesn’t matter.)
Other more sound strategies will come back, potentially in a somewhat altered state. The problem is that many followers of these particular strategies will fall away during the trying times. They usually hop onto the next, then-hot strategy. Hence, the behavior gap. The other option is to double-down on one’s already existing strategy. This has the benefit of consistency, but risks ruin if the aforementioned strategy turns out to be a dud.
The only other alternative is some sort of middle ground. Tracking and selectively implementing a variety of strategies while cumbersome and time consuming, at least provides investors with some measure of diversity. If any particular strategy blows up at least there are other ones, provided they are uncorrelated, to move forward with. The challenge is that investors need to be disciplined in their approach and ruthless in culling unprofitable strategies along the way.
So as Keynes notes the issue isn’t being wrong. The problem is staying wrong. The eternal challenge for investors is distinguishing cyclical underperformance with structural changes which is never an easy task.