By Justin J. Carbonneau (@jjcarbonneau) —
Imagine you’re presented with two investment models. Both hold a concentrated basket of 10 stocks, both are rebalanced monthly and both are built on factor-based investing methods. One of the strategies, let’s call is Model A, is up 58.1% for the year compared to a gain of 20% for the broader market. Ok, that 38% outperformance is pretty impressive. What about the other strategy, Model B, you ask? Well, that’s down slightly with a return of about -0.5% so far this year. So that strategy is behind the market by nearly 20%.
If you were to investing in one of these strategies, which one do you think you’d pick?
Of course, this is sort of a trick question, but before I give you what I think the right answer is let’s try to think about the questions we would want to ask as an investor comparing these two models.
The first question might be what is the long term record of both of these models? Model A has produced a 12% annualized return since inception while Model B, the portfolio that is down slightly this year, has produced a return of 13.9% annually since inception. Over the same time period, the broader market as defined by the S&P 500 is up 7.1%.
Naturally from there we would want to make sure the returns have the same inception date, and in this case they do. The inception date in this case is mid-2003, so the long term records for these two models go back 14 years. This period includes a bull market, a bear market, and periods where different investing styles have worked, so you are getting a return stream through many different market environments.
When looking at return data, it is always good to look at the longest period of time you can and it’s always better if you have at least one full market cycle to analyze in order to see if a strategy has truly stood the test of time.
Model B, despite bad recent performance, wins out over Model A when looking at the long term.
The next question you might logically ask is what is the downside risk of these models and how consistent have the returns been? For example, It would be reasonable to ask the two strategies performed in 2008 (as an example of a bear market period) and how consistent (or inconsistent and variable) the returns have been over time.
In the chart below you will the returns of the two models. Model A has outperformed the market 60% of all calendar years, so 9 out of 15 years. But as you can see, there are some pretty wide variations in return. For instance, in 2006 the model underperformed the market by about 28% and in 2008, it was down 45%, and coming out of the bear market in 2009 the model only generated about half of the return of the market. But there are big up years as well – in 2003 the model was up nearly 3x the market return and in 2013, the model generated a 51.6% return compared to the 29.6% return for the S&P 500.
Model B on the other hand, has outperformed the market an impressive 80% of the time. In a year like 2008, when the market was down 38% this strategy managed to outperform the market by 13% with a 25% loss for the full year. Years like 2012 and 2014 were not great for the strategy, but all other years aside from this year have shown very good results, and in years like 2009 and 2013, the model generated very strong results.
|Year||Model A||Model B||S&P 500|
I think there are a few lessons we can take from this analysis. The first is that short term performance can have a lot of influence over investment decisions, but it does not add any value in those decisions. The longer period you look at returns, the better. The next lesson is you want to make sure that when you are comparing strategies, you are comparing apples to apples. Finally, looking at the risk a strategy exhibits and ow it performs both absolutely and relative to the market in different market environments is another important consideration.
So back to the question — if you were to investing in one of these strategies, which one do you think you’d pick?
Investors looking at long term performance would probably lean toward Model B, but if you are looking at the last say five years, you may choose Model A. But performance is only part of the equation. Perhaps the most important question of all is do you believe in the strategy? So when choosing between two models with good long-term performance, the best choice is often the one you personally believe in because that belief will allow you to stay the course when the model goes through extended periods where it doesn’t work, which all models do.
The portfolios above are model portfolios and are not managed with actual money, and they only have ten stocks so they are very focused, have lots of volatility, and not appropriate for the vast majority investors, but they provide a great illustration of the type of evaluation it takes to select and investing strategy, and the ups and downs you need to weather to follow it.
And in case you’re interested …
Model A is Validea’s Momentum Investing model.
Model B is Validea’s Small Cap Growth Investing model.
You can learn more about what sits at the heart of each of these models on Validea.
Justin J. Carbonneau is Partner at Validea Capital Management and Validea.com. You can follow Justin on Twitter @jjcarbonneau.