There is no shortage of investment strategies out there. In fact, there are so many strategies that is not altogether clear that analysts have polluted their research with findings from prior studies. So assuming you have found a profitable, novel investment strategy you have it made, right?
Wrong. Strategies are easy to adopt. Almost too easy. The challenge is in following through with the strategy through thick and thin. There is no investment strategy that doesn’t experience periods of underperformance. These periods of underperformance try an investor’s soul. As I said in an earlier post all investment strategies go through “unpleasant periods, indeed.”
One could argue that these periods of underperformance make the long run, outperformance of a strategy possible. It is not altogether clear that the insights from behavioral finance have improved manager returns. However John Rekenthaler at Morningstar notes three ways in which the lessons of behavioral finance can be applied to investment management. One way he notes are “mechanical approaches.” He writes:
According to Kahneman, using a simple algorithm often yields better results than relying on the individual judgment of subject-matter experts…the gain in consistency from using an universal system outweighed the loss of losing personal insights. The obvious candidates are strategic-beta funds, which mechanize active management’s strategies. Value, momentum, low volatility…
The challenge in buying into strategic beta funds is that they require a stringent belief in their outperformance. Otherwise the typical pattern of investors buying high and selling low will repeat itself. Jack Vogel at Alpha Architect reviews a paper on “algorithm aversion” or our tendency to discount the value of mechanical approach after we see it make errors, or in the case of investing go through a period of underperformance. Vogel writes:
Successful investors understand that models will fail at times; however, being able to stick with the model through thick and thin is a good strategy for long-term wealth creation.
One of the key parts on having a valid strategy and sticking to it is that the investor has to have confidence in the system. Some of this comes from experience but it also requires sufficient research (theoretical and empirical) to come up with a strategy that we can stick with. Strategy aside David Merkel at the Aleph Blog sums it up well:
My main point is this: every valid strategy is going to have some periods of underperformance. Don’t give up on your strategy because of that; you are likely to give up near the point of maximum pain, and miss the great returns in the bull phase of the strategy.