Why are investors so easily swayed from their chosen strategies? It seems to be an age-old question. As I have written before the ultimate challenge for investors isn’t to find a valid investment strategy. The challenge is to find an investment strategy that you can stick with through thick and thin. This takes both a proper sense of market history and a requisite amount of sitting on your hands. As James Osborne at Bason Asset Management writes:

Even though we simply hate to do nothing, we should. We are not built for it. We are built for action! If it looks broken, fix it! The problem is that what “looks broken” to us is based on our desperate need for immediate gratification and split-second feedback about our decisions. But split-second feedback makes us absolutely terrible investors. In the moment, we can’t take the long view, so we need to listen to our past selves about why we made the plans we did and how we already know what to do in these situations. Generally: nothing.

The problem we have with doing nothing is that it is hard to distinguish between the three major reasons why a strategy undergoes a period of underperformance, or more broadly speaking, a drawdown. A strategy that goes bad, or “blows up“, can happen for three reasons. First it was never a valid strategy to start with, second it has gotten too popular or third it is simply undergoing a period of inevitable underperformance. As noted the challenge for investor is in knowing which of these three states you are in.

The first reason a strategy goes bad is that it was built on sand or said another way it never really existed in the first place. This is the data mining argument wherein if you torture the data long enough you can come up with a strategy that looks good on paper but in reality is built on nothing. A whole slew of sector-related ETFs have been launched based on positive backtests that quite don’t perform once put to the test.

The second reason a strategy goes bad is that it becomes too popular for its own good. James O’Shaugnessy at Investor’s Field Guide would put so-called ‘smart beta’ strategies in this bucket. He writes:

As Jim Grant always says something like, “successful investing is about having everyone agree with you…later.” Where do you think smart beta is today? I think somewhere between hot and mass. If there was an investing version of this you’d probably want to rename “mass” to “mess.”

Think about it another way. Remember all the hot fund managers who have done great managing relatively small pools of money? Once they achieve some measure of notoriety and attract gobs of capital they almost always undergo a period of underperformance. Too much money can ruin a good idea.

The third reason a strategy looks poor is that it is undergoing a period of inevitable underperformance. The S&P 500 for the first decade of this century was pretty much flat, or a ‘lost decade.’ This was due to the high valuations of the dot-com bubble and the implosion of the housing economy. Anyone expecting 9-10% historical returns was deeply disappointed. Hence the rush into gold and bonds at the end of the decade. These types of disasters happen in the stock market: they are feature not a bug.

The fact is that stuff no one expected happens all the time. As investors all we have is history to guide us but we have to take history with a grain of salt. First off history itself can be misleading. Anyone who thinks stock market returns from the 1800s is somehow relevant to today is likely mistaken. Second history is really just a rough guide. Ben Carlson at A Wealth of Common Sense writes:

‘Never’ and ‘always’ have no place in the markets because no one really knows what’s going to happen next. ‘Most of the time’ is a much more reasonable goal, because nothing works forever and always in the markets…To disregard the potential for the unexpected is the height of arrogance and arrogance is rarely rewarded for long in the ever-changing markets.

In a sense investors are always testing their market hypothesis against current results. Investors who are constantly looking for falsifying evidence are likely to find it. The true challenge is distinguishing which of the three above cases you are facing. This ongoing challenge may be the best argument for maintaining a simple investment strategy. The more trendy or esoteric the strategy the more likely that their alpha didn’t exist in the first place or has quickly been swallowed up by market participants hungry for a scrape of outperformance. If you are working from a simple premise it is much easier to face the emotional volatility that comes with being an investors.

Books by authors mentioned above:

A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan by Ben Carlson

Millennial Money: How Young Investors Can Build a Fortune by Patrick O’Shaugnessy

Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere by Tadas Viskanta