- Investors should use strategies that they understand, are academically respected, and are easy to stick with in good times and bad.
- There are a number of statistical measures that can help you determine if a particular investment strategy is a good match for you.
- Even the most carefully researched and thoroughly tested investment strategies should be expected to underperform from time to time.
The more you invest in a marriage, the more valuable it becomes.
– Amy Grant
I waited until I was 33 to get engaged. In addition to someone I was attracted to, I was looking for someone I understood and respected; whose personality was a good fit for me; who was patient enough to put up with my occasionally rowdy behavior, and someone I believed would stick with me for richer and for poorer, in sickness and in health, until death do us part. Fortunately for me, my patience was rewarded, as Mrs. Market Commentator and I have been married 26-plus years and our marriage still makes me happier than I have any right to be.
Similarly, when selecting an investment strategy, you should target strategies you understand, that command academic respect, and exhibit high odds of performing in a way that you will find easy to stick with in good market conditions and bad.
There are a number of statistical measures that can help you determine if a particular investment strategy is a good match for you. In last week’s blog post, I mentioned how Value at Risk can quantify the risk of your portfolio falling below a floor value that could lead to regrettable decisions.
There are a number of additional ways you can measure the ease (or difficulty) of staying married to your investment strategy, for richer and for poorer, and in sickness and in heath. Some of my personal favorites include the potential for drawdowns (maximum drawdowns, frequency of drawdowns, duration of drawdowns); the probability of a strategy underperforming its benchmark (the degree of benchmark underperformance, frequency of underperformance, duration of underperformance); and the ability of a strategy to capture upward market movements and minimize downward market movements.
Just as no one should expect their spouse to be perfect, even the most carefully researched and thoroughly tested investment strategies can let you down from time to time. Granted, there’s irrefutable evidence that the stock and bond market, and the economy as a whole, tend to act rationally over the long term. Nonetheless, both are heavily influenced by human behavior in the shorter run, which means that results can be unpredictable at times.
Take, for example, the recent struggle of investment strategies that seek to generate alpha by favoring securities that have positive momentum. As I discussed in this post, trend following strategies have a long history of generating superior returns over the long term, but results in the short term can be whipsawed when markets abruptly change direction, as happened in December 2018 and January 2019.
One of the most common, costly, and understandable mistakes that investors make is to divorce their investment strategy at the wrong time. Experience may be the best teacher, but human nature causes most of us to over-emphasize recent events when making investment decisions. This can lead to poor returns because investment strategies that are designed to generate excess performance over the long haul cannot be counted on to also outperform during the short term – especially if the markets are behaving badly.
Couples also need plenty of patience and a strong commitment to one another to stay together when their partner goes off half-cocked. Likewise, investors need both patience and understanding to stay true to their investment strategy when it behaves in unexpected ways. Commitment comes from confidence, and confidence comes from understanding. Blind faith can only get you so far. Accordingly, it’s much easier to honor a commitment to an investment approach that you understand, seems logical to you, and follows rules that have been thoroughly researched and tested.
Notwithstanding the foregoing, just as not all relationships can be saved, some investment strategies should be relegated to the rear view. The hard part is knowing when that time has come. Unfortunately, there is no definitive test to know when you have reached that point.
The key is not to break things off in a fit of disappointment or frustration, but to make choices calmly and only after a careful review of the relevant data.
By contrast, letting emotion dictate decisions is almost always a recipe for trouble, as Kathleen Turner and Michael Douglas discovered the hard way in The War of the Roses.
Thank you for reading.
Mr. Market Commentator