By Jack Forehand, CFA, CFP® (@practicalquant) —
It is hard to believe that I am coming up on twenty years of running quantitative investing strategies. And in those twenty years, I have probably made every mistake in the book. Over time, I have learned to look at those mistakes less as a negative and more as a positive way to learn and become a better investor. But in the moment, that doesn’t help a lot to mitigate the pain of making them.
When I look back at my biggest mistakes, and the lessons I have learned from them, several major things stand out. So I wanted to use my article this week to highlight them.
Here are the top five mistakes I have made in my career managing quant strategies.
[1] Thinking the Past Will Always Repeat Itself
I am a big believer in base rates. I think looking to the past to help us learn what might happen in the future is better than trying to make forecasts. But I also have relied on that too much at times. Although we rely on history to tell us which factors work, that history doesn’t ensure they will always work going forward. While I used to look at whether a factor like value will work going forward as a certainty, I now look at it as a probability. Although, I think that probability is high, it certainly isn’t 100%. Markets change. Relationships change. I have learned to use history more as a guide than a definitive way to look at future outcomes.
[2] Underestimating the Second Point of Failure
Early in my career, I focused completely on building strategies that I thought would produce the best performance. I am someone who can stomach a lot of volatility and rarely will panic during tough times. So I built strategies that fit with that profile. The problem, of course, is that not every investor is me. Most investors will abandon a strategy if it underperforms for too long. Jim O’Shaughnessy talks about how investors have two points of failure. The first is that they will panic and sell when they lose money. The second is that they will panic and sell when they underperform. In the world of building active strategies, I have learned that the second is much worse than the first. And that means investment strategies can’t be built in a vacuum. They need to account for the behavior of the investors that will use them.
[3] Relying Too Much on Single Factors
I have always been personally drawn to value. It just makes the most sense to me of all the factors. As a result, I have tended to use the factor over the course of my career more than I should have. Even if momentum makes much less sense to me intuitively, the empirical evidence to support it is just as strong. All factors, no matter how strong their historical performance is, will have long periods where they don’t work. Blending uncorrelated factors is the closest thing to a free lunch you will see in factor investing. I wish I had recognized that earlier.
[4] Not Appreciating the Difficulty of Factor Timing
I am not sure there is a concept in investing where the gap between the theory and the real world reality is wider than factor timing. We are all taught as investors to buy things that are out of favor. So it would make perfect sense that when a factor struggles for a long period of time, an investor should add exposure to it. That is what I did with value in the period leading up to 2020. But the problem is that timing the eventual turn is very difficult, which means that you are likely to think things are about to turn around well before they actually do. And the losses from that timing often exceed the eventual benefits of the turn. Although it makes a lot of sense in theory, factor timing is much more difficult than it seems in practice.
[5] Not Diversifying Metrics
Building a trend following strategy using the 200-day moving average is likely to work well over time. Building a value strategy using the Price/Cash Flow likely will as well. But the same could be said of building a trend following strategy with the 175 day moving average or the 225 day. And the same also can be said of a value strategy using EV/EBITDA. I have learned that trying to be the hero who picks the best metric is not a good idea. Sometimes you will be right, but other times you will be wrong. And those times will likely lose you clients. Using composites of multiple metrics is usually a better approach then trying to pick the right one.
I’m certain that in the next decade I will make more mistakes and learn more lessons the hard way. That is the nature of investing. No matter how much you know, it will always pale in comparison to what you don’t. In looking back at my mistakes, that may be the greatest lesson of all.
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.
