By Jack Forehand (@practicalquant) —
I had the privilege to attend the Democratize Quant conference last week put on by Wes Gray and the team at Alpha Architect. The conference allowed a small group of investors to come together to discuss the practice of quantitative and factor investing and the best way to use these types of strategies to build portfolios.
Despite the fact that the conference focused on investment professionals, there were many lessons in the presentations given that all investors can benefit from and I wanted to share some of those.
1 – Investing is a Learning Process
There was no specific presentation on this topic, but one of the most striking things about the conference was that even though you had some of the smartest and most innovative people in quantitative finance attending, the focus of everyone was on what they don’t know not what they do. Investing is a game where having an ego can quickly destroy you because the market is smarter than all of us. If this group of some of the smartest people in finance recognize that we all have a lot to learn, then all of us should recognize that too. Just accepting that fact alone will make you a better investor.
2 – The Evidence That Factor Investing Works is Overwhelming, and Our Behavior is Part of the Reason.
The fact that everyone at a factor investing conference thinks that factor investing works should be no surprise to anyone, but the evidence to support that argument is overwhelming. Tamara Phillipe from Bridgeway and Chris Meredith from O’Shaughnessy Asset Management both gave excellent presentations about which factors work. As many people would expect, they focused on value and momentum, which are the two factors with the most statistical evidence to support them.
Even though factor-based portfolios will likely produce better returns than the market over time, they still won’t work for many investors in practice. Wes Gray from Alpha Architect gave a great presentation on why investment strategies work that illustrates why this is. The simple answer Wes provided for why factor strategies work is probably the best one – it is some combination of the fact that they take more risk and people are crazy. The more risk part is very straight forward. Finance theory tell us that if you take more risk you get more return. Following a factor like value involves taking more risk than a market portfolio, so it therefore should produce better returns. And that is what happens in the long run.
The people are crazy argument is a little more complex. In theory, investors should always act rationally and make long-term decisions that are in their best interests. The problem, however, is that they don’t. Investors overreact to bad news (this helps value work), and they underestimate good news (this helps momentum). And they also abandon strategies at exactly the wrong times (when they are underperforming). Investment professionals have similar issues. They sometimes worry about their jobs more than long-term returns (this is called career risk). This also leads to suboptimal decisions.
So even though the evidence is clear that factor investing works and everyone knows that, you shouldn’t worry that it will stop working any time soon. Our behavior as human beings is likely a big part of why.
3 – The Risks You Don’t Pay Attention to Can Be the Ones That Hurt You
There are many obvious risks in investing. Investors are geared to look for these risks and manage them. But there are also risks that aren’t as easy to identify. Corey Hoffstein from Newfound Research gave an excellent presentation on one of these, which he called “timing luck”. Timing luck is the idea that two investors who follow the exact same investment strategies can get very different returns in the short-term if they rebalance at different times of the year. If you follow a portfolio with 50% bonds and 50% equities, the date that you choose to rebalance back to your target weights every year can make a significant difference in your returns in the short-term. That may not seem like a big deal, but it can have major long-term implications. For investors, that deviation from the target portfolio in the short-term can be enough to lead to panic in a challenging period, which can lead to abandoning an investment strategy. For professionals, it can be the difference between a client firing you or staying the course.
How do you combat this? The answer is pretty simple. You can either run multiple portfolios that rebalance at different points in the year, or you can rebalance portions of the same portfolio at different times.
This is just one of these types of risk that exist in investing. There are many others. The overriding point is that all of us often focus on selecting the right investment strategy, but spend much less time on the hidden risks embedded in how we implement it. That can be a big mistake.
4 – Failure is More Important Than Success
Barry Ritholtz of Ritholtz Wealth Management closed out the conference with a great presentation titled “The Fine Art of Failure”. He focused on how all of us can learn much more from our failures in life than our successes. When we succeed in life, we tend to want to take credit for it, and when we fail, we tend to want to blame others or factors outside our control. That is the exact wrong mindset to have.
A great example of this is Ray Dalio. He is one of the most successful investors of all time, but if you read his book or listen to an interview with him, you will hear him focusing much more on what he did wrong than what he did right. That is a mindset all of us can benefit from.
Another interesting thing I learned from Barry’s presentation is that you should always challenge the things you hear to make sure they are valid. A great case that illustrates this that he discussed is Jim Collins’ book “Good to Great”. The book is considered one of the best business books of all time, but the evidence supporting it is questionable. In the book, he looked at the factors that led good companies to become great. In the ten years prior to when the book came out, the companies he featured truly were great. Their businesses were successful and their stocks beat the market by a wide margin. But in the next decade after the book was published, things didn’t go so well. Their average return was well behind the market and two of them were effectively 100% losses (Circuit City and Fannie Mae). So those “good to great” principles didn’t identify companies that achieved the lasting greatness the book talked about.
Investing is All About Learning
The overreaching theme of all of these principles is that investing is a practice that requires constant improvement. Attending this conference was part of that constant learning process for me, but everyone who invests should find their own way to regularly build their knowledge. The more you can do that, the better an investor you will be.
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.