By Jack Forehand (@practicalquant)

One of the most dangerous games we all can play in investing is the game of looking back and thinking about what we should have done. Hindsight bias leads us to believe that we should have known all sorts of things that there was no way to know at the time, and that leads to conclusions that would have been very difficult to draw with the information that was available then. But having said that, learning lessons from both successes and failures is an essential part of being a successful investor and continuing to improve.

I have now been managing quant portfolios for over 15 years and have made enough mistakes to cover far more than the thousand or so words I will write here. But I wanted to share some of the biggest ones in an effort to continue my learning process and to hopefully help others not make the same mistakes I did.  

So here are a few notes that I would have sent to myself over the years if I could go back and do it all over again.

Investing Models Have to Be Built for Human Beings

Dear 2004 Jack,

You have been running quant models in a simulated environment for a while now. But you are about to launch them as actual money management portfolios and manage actual people’s money. And that will be a game changer. You can no longer assume that an investor will stay the course during bad periods. No matter how many computer simulations you run, nothing will prepare you for this. People do the wrong thing at the wrong time. They have an uncanny knack for abandoning strategies at market bottoms and when underperformance is about to turn around. Your strategies can be great in testing, but if investors can’t stick with them, they will never realize their potential. You need to recognize that human behavior needs to be a central part of the construction process for any investing strategy.

Sincerely,
2019 Jack

I wish I had Daniel Crosby’s excellent book, The Behavioral Investor, when I started out in investing. If I did, I would have realized that human behavior can’t be a secondary factor when building investing models. It has to be front and center. I also would have realized that it isn’t just the investors in the models I build that are affected by behavioral biases. They affect all of us, including me. And there is no amount of training that will change that. If I could talk to myself back when I started, this is probably the most important lesson I would impart.

The Bad Periods Are What Define You

Dear 2006 Jack,

Congratulations on the performance of your quant models. The concept of building factor-based models to follow the strategies of legendary investors and the outperformance in the first few years of running them is impressive. But you need to understand that luck plays a big role in both your positive and negative outcomes in investing. In addition to the great period of performance you just went through, your career will also include long periods of underperformance. And it will be what you do during those periods that will define you. So get ready, because as good as things are now, they will be equally as bad when things aren’t working. Just remember you are never as good as you think you are when things are going well and never as bad as you look when things are going poorly. Keeping a level head will be the key to long-term success.

Thanks,
2019 Jack

Our early experiences in investing often define what we expect going forward. For me, the early part of my career happened to come during the 2003 to 2006 period when quantitative models, and particularly value-based quant models, were beating the market by wide margins. When you are new to investing and something like that happens, the tendency is to chalk it all up to skill rather than understanding that a significant portion of it is luck. I was certainly guilty of that. Even if you had told me how challenging the underperforming periods would be, I am not sure if I would have believed you. You need to see those types of things with your own eyes and feel the pain they cause to truly understand and appreciate them. That isn’t to say that the bad periods have in any way shaken my faith in the long-term success of quantitative models, because they haven’t. The evidence still shows that these types of models work over the long-term. But the bad periods have led to an appreciation that the pain of underperformance is the required price that must be paid for the gains that factor-based models produce.

Bear Markets Must be Experienced to be Understood

Dear 2008 Jack,

You think you know what a bear market is. You have studied them. You have analyzed market history to look at their frequency and severity. But here’s the thing: what you are about to experience is something no textbook can teach you about. You will lose money. You will lose clients. Your house will be worth much less. Since you are in the financial business, basically all the income and assets you have will fall simultaneously. Your head will tell you throughout the experience that every time this happened before was a buying opportunity. It will tell you that things will inevitably get better. But the feeling you will have will tell you the opposite of all of that. Your ability to control that feeling and see the facts when everything is falling apart around you will determine your success. Also, by the way, this experience will likely impact your feelings about risk for a very long time. You will want to be far more conservative in the wake of this than you should be. You will see major bear markets coming in ordinary corrections from here on out. So try to keep the base rates in mind and remember that this is the second worst bear market ever. Future declines are not likely to be like this.

Yours Truly,
2019 Jack

This lesson may seem obvious, but it goes back to the point I made before about having to experience something to know what it means. It is easy to look at market history and see major declines. It is impossible, though, to know what it feels like when everyone around you thinks the world is about to end. Unfortunately, the only way to know the pain of bear markets is to experience them. I learned that first hand in 2008.

Redefining My Definition of Work

Dear 2011 Jack,

You love to build quant models. You have learned so much about how to create them and properly test them so the results have statistical significance. But your meaning of the word work needs to be adjusted. You don’t need to be running tests or building investment strategies to be working. Sitting and reading a book on investing (or even a topic outside investing) or listening to a podcast (you will figure out what these are later) is often a more productive use of your time. Even spending time on Twitter will be very beneficial. Once you figure this out, you will become a much better investor (it turns out there is a reason Warren Buffett sits there and reads books all day). It even goes further than this. Sometimes the best ideas you have to enhance your investing approach will come when you take a walk and do nothing at all. So focus on keeping your head up sometimes in addition to keeping it down building investment strategies. You will find that some of your most productive times will come doing things that you don’t currently consider work.

Best Regards,
2019 Jack

Of all the lessons I have learned in investing, this was probably the hardest. I am wired to believe that certain things are work and certain things are not. I have a hard time reading a book or listening to a podcast and thinking that I am using my time productively. But I have learned that I am totally wrong about that because doing those things has made me a much better investor.

Mistakes as a Learning Opportunity

These are obviously only a subset of the mistakes I have made in my career. Everyone who manages money, whether it be for yourself or other people, is going to make them. The key is to embrace them as a learning opportunity rather than dwelling on them. In the end, it isn’t your mistakes that define your investing career. It is how you react to them. Hopefully I can continue to use mine to make me better.

Photo: Copyright: 123rf.com / alaskajade

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