By Jack Forehand (@practicalquant) —
With the release of Michael Batnick’s new book “Big Mistakes: The Best Investors and Their Worst Investments” last week, the topic of mistakes in investing has been front and center on Twitter and on investing blogs. Many investors view mistakes as a topic they want to avoid. Most of us don’t want to admit when we’re wrong and we certainly don’t want to revisit it in the future and bring back the pain associated with past mistakes. But if you look at the best investors in the world, you will see two common characteristics.
- They make lots of mistakes
- They spend much more time analyzing their failures than their successes
As human beings, we sometimes have to overcome the way we are wired. When we are successful in life, it is natural to want to think we were the cause of that success, whether it be through our intellect or our hard work. When we fail, we tend to see outside factors as the reason. We think we did everything we could, but luck or the actions of other people derailed what would have otherwise been a strong success.
There are several problems with this thought process. First, it is often wrong. When we fail in life, we are often the cause of that failure, whether we see it or not. Second, it derails the learning process. Failures are a much better source of knowledge and wisdom than successes. Those that can look at their failures, break down what went wrong, and learn from it are much more likely to have success in the future. And future success is what matters.
Some investors believe that quantitative and factor investing are areas where mistakes are less common. After all, if you have a computer running the show that has no emotions or biases, the result should be a process less prone to mistakes. There is some truth to that, but it certainly doesn’t hold in all cases. In the spirit of Michael’s new book, I wanted to take a look at a few common mistakes, all of which I know I’ve made in my investing career, that investors using factor-based strategies tend to make.
1 – Thinking the Past Always Repeats Itself
At its core, factor investing is about odds. If you look at factors that have outperformed the market in the past and follow them, you increase your odds of beating the market in the future. Those odds are never 100%, though, even over the long-term. Factors that have worked historically sometimes stop working. To compound the problem, when you are in the middle of a period where the factor you follow is struggling, there really is no way to know whether it will work again in the future. If it has proven itself over long periods of time, it probably will work going forward, but you can never know for sure.
Consider the current example of the Price/Book ratio. The Price/Book in many ways has been the foundation of the historical research that shows that value investing works. It was the factor used to identify value in the famous Fama and French 3 factor model published in 1992. It is also the most widely used value metric by practitioners. Despite all the research supporting it, the Price/Book is currently in the midst of one its worst performing periods ever. Not only has it performed very poorly in recent years, it now trails the market over a period spanning multiple decades.
An investor following a Price/Book based strategy is now presented with a question that has no answer: Has the factor stopped working for good?
On one side of that argument is a long period of data supporting the factor. On the other is the fact that the world changes. Those changes may have made Price/Book no longer relevant. This paper from O’Shaughnessy Asset Management highlights the reasons why better than I ever could.
Corey Hoffstein of Newfound Research recently wrote an excellent article about this. He found that the median time period it would take to say with a high level of statistical significance that the Price/Book no longer works is 67 years, longer than most investor’s investing lifetimes.
The overreaching point here is that you can’t just assume what has worked in the past will continue to work in the future. The Price/Book strategy may reward investors for the pain they are experiencing now. It may never work again. Just the fact that it has worked historically isn’t enough to definitely say it will work going forward.
2 – Matching a Short-Term Time Horizon With a Long-Term Strategy
Factor investing works over long periods of time. In the short-term, the periods of underperformance can be both long and brutal (see Price/Book example above). The ability of an investor to sit through those periods and not abandon the strategy is crucial to long-term success. Most investors aren’t up for that, though. It is hard for some to sit through months of underperformance. It is hard for many to sit through a year. It is next to impossible for almost everyone to sit through periods of underperformance that can be as long as a decade. But that is what it takes to successfully implement a factor-based strategy. You need an iron will and a willingness to tune everything else out and follow the strategy with complete conviction. Many people think they have that conviction when they start following factor-based models. Very few ultimately will have what it takes when the multiple years of pain arrive.
3 – Thinking That Factor Strategies Are Emotion and Bias Free
One of the major selling points used by those of us who use factor models is that they remove emotion and biases from investing. There is a lot of truth to that, but it’s not the complete story. Even if you follow a factor model with the utmost discipline and consistency, there are still decisions that need to be made along they way. Even though Artificial Intelligence is getting better every day, at this point those decisions are still primarily made by humans.
What are these decisions that need to be made? First, selecting the factors to follow is a decision fraught with issues related to bias and emotion. Do you follow the factor with the best historical performance? Do you try to incorporate mean reversion and follow a factor that has been out of favor in recent years? Do you combine multiple factors together? Those are just a few of the many questions that need to be answered.
Even after making those decisions, you will be faced with many others along your long-term investing path. The question above of what to do when you question the long-term efficacy of a particular factor is a great example of that.
Just because you are using a disciplined investing process doesn’t mean there won’t be decisions to be made. Those decisions will introduce the exact issues into the equation you are trying to eliminate. This isn’t to say that factor investing isn’t a huge improvement over standard active approaches for eliminating bad decisions. It clearly is. But it isn’t perfect and many often make the mistake of assuming it is.
In the end, following a disciplined repeatable process can eliminate many common mistakes. But it isn’t a panacea. Every investing approach is subject to the mistakes of those following it. Factor investing is no different. If you are honest with yourself about those mistakes and look at them as an opportunity to learn, you can substantially increase the odds of achieving your investing goals. If you don’t believe me, go out and buy Michael Batnick’s book. It will open your eyes to the fact that investing isn’t about eliminating mistakes, it is about learning from them.
Photo: Copyright: bluebay / 123RF Stock Photo
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.