“All Strategies “Blow Up” is the title of post by Adam Butler at GestaltU. In this excellent post Butler talks about how poorly defined strategies blow up but also “why even good strategies must test investors’ resolve every now and then in order to deliver long-term excess returns.” The distinction is an important one.
In a recent post I talked about how “drawdowns happen” and investors need to get used to it. In short, drawdowns (of whatever type) test investors’ resolve on an continual basis. As I note it is good to remind ourselves of this reality before it occurs rather than in the midst of one.
The challenge of drawdowns (and blow ups) apply not only to broad risk premia but also strategies as well. The reason for this is that these strategies undergo periods of underperformance. If following value and/or momentum strategies were easy everyone would be doing it. I note in my book the reason why these strategies exist (and are profitable) is that they are “psychologically difficult to follow.” I particularly like how Butler explains the issue:
One risk that both value and momentum premia exhibit is the risk of under-performing the assets being ‘timed’ for extended periods of time. This can be quite painful for investors, as they watch their friends’ more traditional portfolios appreciate while their portfolios stagnate. As a result, investors become infected with the suspicion that the factors they are harvesting are somehow ‘broken’, or no longer exist. This fear and doubt compels many investors to abandon these strategies toward the tail end of under-performing periods, leaving money on the table for more disciplined investors to reap. If these unpleasant periods did not exist, everyone would follow the strategy and no one would abandon it; thus no one would leave behind any excess returns!
Unpleasant periods, indeed. As Butler notes this is second or third-order investment thinking but the type of thinking one must undertake to understand investment strategies and processes. I am looking forward to the additional (promised) posts on the topic.