Thursday, August 3, 2017

Revised RSS Link


I renamed the blog URL. Please please kindly update your RSS feed with the address below:


Wednesday, July 5, 2017



Dear readers,

It’s been 2 years since I started this little blog.

This site has been a great way to journal my investment philosophy and present some quantitative research. Along the way, I’ve received lots of great feedback from many of you in the comment sections and by e-mail.

I want to announce that I am moving this blog to a new site: The purpose of the new website is to allow for a bit more functionality.

If you are using an RSS feed, please kindly update it with the address below:

Thanks again for your readership and support!


Tuesday, June 20, 2017

Asset Allocation Part 1: The Basics

Source: Randy Glasbergen,

As investors, we want to reap the power of compound interest over the long-run. That is how we build real wealth. But what should we invest in and how can we most efficiently allocate our savings?

This is a 3-part series of posts on asset allocation that forms the foundation of my investment philosophy. This series will tie together a lot of items I’ve been writing about over the past 2 years. Here is an outline for this series:
·         Part 1: The basics – what are asset classes, why stocks form the core of portfolios and how traditional diversification in other asset classes helps improve our Sharpe Ratio
·         Part 2: Strategic Asset Allocation (SAA) – determining the allocation for a specific investor, comparing passive vs. active funds for implementing SAA, and looking at the pros & cons of SAA
·         Part 3: Tactical Asset Allocation (TAA) – how we can more efficiently allocate to asset classes and achieve higher risk-adjusted returns

Let’s begin with the basics…

A Brief Look at Major Asset Classes

The investable universe can be categorized into what’s known as asset classes, or groups of investments that are liquid, distinct and not highly correlated with each other. 

The most common asset classes are equities (stocks) and fixed income (bonds). Domestic and foreign equities are treated as separate asset classes, since they have different risk & return profiles. Then there are the alternative asset classes such as commodities, real estate and private equity.

Historically, stocks have provided the highest returns with bonds coming in at second place. Wharton professor Jeremy Siegel shows this over a 210-year period from 1802-2012:

Source: Stocks for the Long Run, Jeremy Siegel

Let’s look at the characteristics of each major asset class to help us understand the above chart better.


Equities are part-ownership in businesses. When we invest in a broad stock index, we’re investing in many of the largest companies across all industries and sectors. And as owners of these companies, we believe society will continue to innovate and prospser as it has for all of human history. In the 2013 Berkshire Hathaway Shareholder Letter, Warren Buffet wrote:
"Charlie and I have always considered a 'bet' on ever-rising U.S. prosperity to be very close to a sure thing. Indeed, who has ever benefited during the past 237 years by betting against America? If you compare our country's present condition to that existing in 1776, you have to rub your eyes in wonder. And the dynamism embedded in our market economy will continue to work its magic. America's best days lie ahead." – Warren Buffet

Equities give investors returns through dividend income and capital growth. One key feature of equities (unlike owning commodities or physical real estate) is that they benefit from the power of internal compounding: many companies typically re-invest part of their earnings back into expanding the business.

Another key reason that equities provide significantly higher returns than other asset classes is due to the risk they carry. Equity earnings face uncertainty of future demand, input costs and competitive forces, to name a few. Shareholders share in the fortunes and misfortunes of companies, with no guarantee of principal repayment. And as well all know, bear markets in stocks can be severe both in terms of magnitude and duration: 



A bond is a loan that gives investors returns primarily through interest income. This income stream is relatively stable and the investor’s principal is returned at maturity.

The major risks surrounding bonds are interest rate and credit risk. Bonds are offered in various lengths (time to maturity). The greater the length of the loan, the higher our exposure to various risks. Let’s first look at interest rate risk.

If we buy a single bond issue, then as rates rise, the value of our bond falls. This is because we are stuck receiving the older (lower) interest rate. However, we have less interest rate risk if we instead invest in a bond fund. A bond fund holds a collection of several bond issues and tries to maintain a target length. As some bond issues in the fund mature, they are replaced with new funds. Thus, if interest rates were to rise, we would take a hit on the bonds currently in the fund but we would get a discount on new bonds added to the fund. Therefore, bond funds are less sensitive to interest rates.    

Even during the 60s and 70s, when 5-year Treasury rates went from 4% to 16%, investors in a 5-year Treasury bond fund didn’t lose much sleep:

Source: US Federal Reserve Board,

Investors in government bonds have fairly low credit risk, as governments (particularly in developed countries) have stable revenues through taxes. This lower credit risk generally results in lower bond yields for investors.

Investors of corporate bonds carry company specific-risk, but not as much as shareholders do. This is because corporate bond investors not only receive coupon income and principal repayment, but also have priority claim on company assets over shareholders in the event of bankruptcy. Due to their lower risk profile, bonds don’t provide as high returns as stocks.


Commodities include base metals (eg. copper, aluminum), precious metals (eg. gold, platinum), agriculture (wheat, soybeans) and energy (eg. oil, natural gas).

The return potential for commodities is not as high as stocks for several reasons:
  • By definition, commodities and inflation are tied together:
  • Commodities have storage costs, don’t generate any income, and their returns can’t be compounded internally the way that stocks do.
  • Companies take raw commodities as inputs and continually manufacture new, innovative products at a markup (thanks to barriers to entry, intellectual property, brand power, etc.).

Real Estate:

An investment in Real Estate can either be direct (eg. owning property) or indirect (eg. REITs).

Direct real estate provides rental income and capital appreciation. The downsides are that direct real estate is illiquid, has high transaction costs and on-going costs (eg. property taxes and maintenance). Furthermore, the return potential for direct real estate is not as high as stocks for several reasons: 
  • Increasing supply is used to meet increased demand, which helps curb price appreciation
  • Local housing prices are anchored to inflation through rents and incomes. If housing prices are rising rapidly faster than rents and incomes, it is not sustainable since it means residents are either stretching themselves to own a home, or that the alternative to buying (renting) is more economical.
  • Real estate prices are impacted by interest rates the way bonds are. When rates rise, mortgages are tougher to afford, and housing prices fall. Conversely, when rates fall, housing prices rise. In a low interest rate environment like today, housing prices are high. If you were to buy a home and rent it out, the rental yield would be low, similar to the interest yield on a bond.
  • The local salaries that drive real estate prices are generated by the business sector. It would be unsustainable for companies to increase wages for their employees faster than the growth in business revenue. This is an indirect way to show that real estate is inferior to stocks.

The following chart shows US home prices in real terms since 1880. We see that housing has barely outperformed inflation over the long-term despite a growing population. 

Source: Robert Shiller, 2012

It should be noted that REITs (real estate investment trusts) on the other hand act more like stocks, since companies are re-investing capital to buy new properties or finance the development of new projects.

Before we conclude the brief tour of asset classes, I would like to point out that each asset class doesn’t operate in a vacuum. See our previous post: Markets are Interconnected.

How Diversification Helps

Because of their high long-term return potential, equities form the core of traditional investment portfolios. However, we cannot passively have our entire portfolio in equities since they are volatile. 

Source: prabook

In 1952, Harry Markowitz discovered an interesting property: by adding bonds to an equity portfolio, you can significantly reduce portfolio volatility without sacrificing much in the way of returns. The graphical representation of this is called the Efficient Frontier and forms the basis of Modern Portfolio Theory. It is shown below.

The purpose of the Frontier is to show that proper asset allocation can give investors more reward per unit of risk that they take. For example, portfolio B on the Frontier contains 33% bonds while portfolio D contains 100% bonds yet B has significantly higher return for the same level of risk as D.

How can this be? The key is that stocks and bonds tend to be uncorrelated. While both stocks and bonds have positive expected returns in the long run, they tend to respond differently to market forces (though not always). So, by diversifying into multiple, uncorrelated assets, a downturn in a single holding won’t necessarily spell disaster for your entire portfolio.

Stay tuned for part 2, in which we’ll look at strategic asset allocation.

Sunday, April 30, 2017

Scenarios for Momentum Investing

source: babaimage

In the previous post, we reviewed momentum’s robustness and saw how it stood the test of time. We also stress-tested the Global Equities Momentum (GEM) strategy and saw that its performance is not overly sensitive to changes in the strategy’s settings (i.e. the 12-month lookback period and the monthly rebalance period).

In this post, let's run various scenarios to see how us momentum investors would fare in each of them.

Base-case scenario:

The most likely scenario is that society continues to innovate and prosper as it has for all of human history. In the 2013 Berkshire Hathaway Shareholder Letter, Warren Buffet wrote:

"Charlie and I have always considered a 'bet' on ever-rising U.S. prosperity to be very close to a sure thing. Indeed, who has ever benefited during the past 237 years by betting against America? If you compare our country's present condition to that existing in 1776, you have to rub your eyes in wonder. And the dynamism embedded in our market economy will continue to work its magic. America's best days lie ahead." – Warren Buffet 

I will expand on this in a future post and include items from the excellent book “Stocks for the Long Run” by Jeremy Siegel.

Nonetheless, we want to test all types of negative scenarios to see what impacts they would have on portfolios that follow a systematic momentum model such as GEM.  Let’s begin with the most unlikely scenario.

Armageddon scenario:

A nuclear holocaust. Killer contagion. Supervolcano eruption. An asteroid hitting the earth.

While these and other doomsday scenarios have a low likelihood of occurring, they could cause equity markets to suffer heavy and sustained losses. But if such a scenario were to happen, you would have far bigger things to worry about than your portfolio.

Gradual equity market decline scenario:

This can be due to changing demographics, falling population levels, etc. This is a bit more realistic than an Armageddon scenario.

The chart below shows our long-term population growth

source: Wikipedia

Since 5000 BC, population growth has roughly doubled every millennium. But starting around the 1800s, population growth entered an accelerated growth period. It can be argued this population explosion has been the main driver for long-term GDP growth and hence equity returns. It may be argued that this growth is not sustainable forever, leading to a stagnant population growth at some unknown future time. Population rates have also been shown to fall as developing countries gain an increased standard of living. 

Whatever the underlying reason is, let's suppose hypothetically that equity markets decline gradually. How would a trend following or momentum strategy like GEM adapt? The trend of equities would be down and we would simply be in the safety of bonds. But what's less easy to answer quickly is if equity markets go sideways. Let's take a look.

Erratic, sideways equity market scenario:

As discussed in a previous post, current equity market valuations and bond yields mean that we should set low returns expectations for passive balanced portfolios over the next 10 years. It is likely that equities can churn sideways for the next decade or more.

Trend following and momentum strategies tend to suffer in these types of erratic, sideways markets. But what, quantitively, would be GEM’s performance in such a market?

In the post linked above, we looked at the 10-year sideways equity market that began in 2000. We showed how over this period, GEM produced an 11.4% annual return compared to just 2.8% annual for a 60/40 stock/bond balanced portfolio.

In this post, let’s test an even more extreme scenario: How would momentum perform during the 30-year sideways market in Japanese equities that began in the late 80s? 

We test an absolute momentum strategy that each month-end, invests in the MSCI Japan index if the past 12-month performance of that index is greater than that of T-bills. Otherwise we invest in the US Aggregate Bond Index. Simple.

The chart and table below shows what happens since Jan 1971. 

We see that Absolute Momentum outperformed Japanese equities significantly. The strategy produced an extra 560 bps of return while also considerably reducing volatility and maximum drawdown. The strategy made an average of just 1.5 trades per year and was invested in Japan for 56% of the time since 1971.

OK. You might be thinking “Yes, but you had the benefit of switching into US bonds, which were in a major bull market in the past 30 years.” Fair enough.

Let’s see how our momentum strategy fared if we could only switch into cash for safety. The chart below shows we still would have outperformed.

We see that Absolute Momentum now produced only slightly better returns than Japanese equities. However, we still benefited from having significantly reduced our maximum drawdown. And this was done with an average of just 1 trade per year and being invested in Japan for 64% of the time since 1971.

I should note these are results for absolute momentum (comparing a risky asset to cash). You would reduce the concern of a sideways-market scenario by adding another equity market and running dual momentum.

Rising interest rate scenario:

We touched on the idea that future bond returns will be nowhere as great as they have been over the past 30 years. This will reduce the performance of momentum/trend following strategies that use bonds for safety, but it won’t hurt performance too much for 2 reasons:
  1. The GEM strategy has only been in bonds 30% of the time since 1970. If we replace bonds with cash, GEM’s annual returns fall from 17% to about 14.5%. This would still be a respectable return.
  2. Even in the worst-case interest rate environment (1962-1982 when 5-year yields went from 4% to 16%), an aggregate bond fund still doubled (growing at 3.5% annually). This is due to the nature of bond funds continually replacing maturing bonds with new issues to maintain a constant maturity. See chart below

 Thus, dismal future bond returns won’t be the end of the world for momentum strategies.

OK, but what if the stock-bond relationship changes? The chart below shows stock-bond correlations over the past 100 years.

Despite the relation changing significantly over this time, momentum strategies have been shown to work (on a decade-by-decade basis) over this period as we saw in the last blog post.

Structural market change scenarios:

Thanks to technology, the speed at which industries are changing has never been faster. We are seeing some companies rapidly gaining market share while some are becoming obsolete. As Google’s Sergey Brin discussed in a recent interview, it is next to impossible to know what the future will look like. Because the GEM strategy invests in large, diversified ETFs, this uncertainty is not a major issue.

What about a scenario where emerging markets gain dominant market share - would this threaten the rest of the world? We showed in a previous post that this is not a major concern, since the GEM strategy invests globally. Furthermore, companies in all parts of the world are growing their global presence.

How about baby boomers retiring in large numbers - will they destroy the stock market? Ben Carlson has a blog post up today that looks at this question and shows why this is not a concern. 

What about currency risk? Non-US GEM investors may see their domestic currency rise rapidly while they are holding foreign assets required by GEM. For example, from 1985-1995, the Japanese Yen rose over 300% relative to the US dollar. We showed that despite this, Japanese investors still would have come out ahead by following GEM.

There are far too many of these scenarios to list here. The perma-bear approach is to worry excessively about every negative scenario, to never invest and never grow your wealth. This is a sure way to ensure that your future self will hate you.    

Concluding thoughts:

We can summarize the main scenarios and our findings as follows:
  • Trending (up or down) equity market - During bull markets, a momentum strategy such as GEM is concentrated in equities and during bear markets, it is concentrated in bonds. This more efficient asset allocation allows GEM to significantly outperform a traditional approach (passive 60% equity, 40% bond portfolio) in terms of both excess returns and reduction in volatility & drawdown.
  • Sideways equity market - GEM still wins. During the 2000-2010 sideways market in global equities, GEM did an 11% annual return compared to just 3% annual for the traditional portfolio. In an extreme scenario where we switch only between a single, sideways equity market and cash for 30 years, momentum still shows slightly higher excess returns. In both these examples, momentum provided a significant reduction in volatility and drawdown.
  • Sudden catastrophic event scenario - GEM would underperform buy-and-hold, assuming it is fully in equities at the time of the event. 

The likely very-long-term scenario is growing economic prosperity and equity markets. However, the next decade may be a period of dismal returns and sideways markets due to current equity valuations and bond yields. A catastrophic event scenario, while possible, is not very probable. 

That being said, we don’t know what the future will bring. The beauty of trend following and momentum is we don’t need to make any forecasts. Trend following adapts to market environments and actually requires less faith than other approaches. For example:   
  • Someone that has all their savings stowed under the mattress requires faith that cash will do better than inflation
  • Those that invest in the traditional portfolio require faith that future expected returns (despite being very low) are still worth the risk compared to being in a high interest savings account
  • Value investors constantly require faith that markets will mean revert

(we will do a more in-depth comparison of trend following and momentum to other investing strategies in a separate post).

Finally, I always get asked a lot about a scenario we didn't discuss here: What would happen if everyone began following a momentum strategy? Despite everything presented in this post, trend-following and momentum strategies are not a slam dunk way to riches. It takes a lot of discipline to stick to an active strategy when it suffers the inevitable period of volatility, uncertainty or under-performance. More on this in a future post. 

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Monday, January 2, 2017

Testing Momentum’s Robustness

Happy new year!

I have noticed that my quantitative posts get the most readership and discussion. So this year, I’ll be posting a lot more research and will start the year off by exploring momentum’s robustness.

There are two good ways to test the robustness of a rules-based trading strategy:
  1. The test of time - how does the strategy behave in different market regimes?
  2. Parameter sensitivity – how stable is the performance if the strategy’s parameters are varied
Let’s look at each of these separately.

Test of Time

The goal is to see how well a strategy performs over a very long-term, under different market conditions. Gary Antonacci has some good articles on the importance of having a long-backtest period (see Bring Data and Bring More Data).

In 1937, Cowles & Jones did the first paper showing that 12-month momentum works. In 1967, Robert Levy did the first computer backtest on momentum. In 1993, Jegadeesh & Titman wrote their seminal paper showing 3-12 month momentum works. Also in that year, Eugene Fama (father of the efficient market theory) called momentum the "premier anomaly."

In 2013, Geczy and Samonov published a paper showing a momentum backtest that went back over 200 years. The following year, Greyserman and Kaminski did an 800 year backtest. Both papers show that the momentum anomaly is persistent over the long-run.

The table below is how the Global Equities Momentum (GEM) strategy has performed from 1971-2015. 

While these results are nice, looking at cumulative outperformance over a backtest period is not enough – we should also look at individual periods within the data.

I did a post a while back showing what happens when we add Gold to the GEM model (see Should we consider gold?). GEM’s annual returns (since 1970) jumped from 18% to 21% by including gold. At first glance, this sounds exciting. But a closer look showed all this additional gain came from the 1970s when the US went off the gold standard. No longer being suppressed, the price of gold rapidly rose in just a few years. We need to be careful not to be misled by these types of one-time events.

The graph below shows that equities (red and green lines) had a secular bear market during the 1970s and 2000s, and a bull market during the 80s and 90s. In both market types, GEM (blue line) did well.

Let’s dig further with a longer period of data. How does momentum do on a decade-by-decade basis?

Meb Faber looked at this in his paper “Relative Strength Strategies” (read here). The table below shows the outperformance each decade of a US sector momentum strategy (hold the top performing sector and rebalance monthly) compared to the entire US stock market.   

While some decades were better than others, momentum had positive alpha every decade since 1930. This is an indication that the momentum anomaly has persistence.

OK, all this looks nice however…

While momentum (and all trend-following) strategies tend to perform well in trending markets, they typically fail in very erratic, sideways markets. An extreme market-regime test is to see how momentum would fare using Japan’s Nikkei stock index, which has traded sideways for 30 years. This will be the topic of my next post. Let’s continue on.

Parameter Sensitivity

Any quantitative strategy has one or more input variables. GEM has two: the lookback period (length of time over which past performance of assets is measured) and rebalancing period (how often you check for a new trading signal). GEM’s recommended parameter settings are 12 months for the lookback and monthly for the rebalance.

By varying these input parameters, we want to see how the strategy’s performance changes. I want to be clear: this is NOT done to find the optimal parameter settings. That would be data mining. Instead, this test is done to determine the model’s sensitivity. A sign of a robust trading strategy is one whose performance is not affected by small changes in its settings.

Note: The analysis that is presented below was done using daily data and MATLAB software. Source code and data is available upon request. 

We first look at how GEM’s performance (between 1988-2016) changes as we vary the rebalancing period from 1 to 100 trading days while keeping the lookback period constant at 12-months.

We see from above that a rebalancing period between 15-25 trading days results in returns performance that is stable while providing high returns and low portfolio turnover. This confirms the recommended setting of 20 trading days (1 calendar month).

It’s interesting to see that a rebalancing period less than 10 trading days results in very high portfolio turnover and with lower returns (due to whipsaw losses). There is absolutely no reason to be doing weekly rebalancing with GEM.

Next, we look at how GEM’s performance changes as we vary the lookback period from 30 to 500 trading days, while keeping the rebalancing period constant at one calendar month.

We see above that any lookback period less than 200 trading days results in higher whipsaw losses and higher portfolio turnover. A lookback between 250-350 trading days results in stable performance with fairly low portfolio turnover. This confirms the recommended setting of 12 calendar months (250 trading days).  

The 12 month look back period was first discovered by Cowles and Jones in 1937. Various other research since then has shown momentum works best with monthly rebalancing and a 12-month lookback period. The results above confirm this, as well as demonstrate how the prior research has held up since it was first published.


Momentum has passed several checks for robustness. It has proven itself over a long backtest period and in different market regimes. In addition, the performance of a simple momentum strategy like GEM is not sensitive to small changes in the strategy’s parameters.

I often get asked about using much shorter rebalancing and lookback periods to be able to adapt faster to market changes. Up until now, I have just verbally been telling people that this would create higher # of trades and whipsaw losses. Now I can back up my recommendation with quantitative evidence.

I leave you with Dilbert’s take on model sensitivity.

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Tuesday, December 27, 2016

The Blogosphere’s Greatest Hits of 2016

As 2016 comes to a close, I want to discuss some of the best writing I’ve read on the financial blogosphere this year. The posts below were written by several different authors. Even though these folks follow their own investment strategies, they all echo the same investment philosophy as mine.

Here are this year’s highlights in no particular order…

1. Simple vs. Complex by Josh Brown
"The world itself is complex, as are the investment markets. So the first notion that many investors begin with is that they need something equally complex to protect them or help them win. This is a logical fallacy, but a widely held one. I’ve come to believe that getting better as an investor is a reductive process rather than a contest to see who can add the most bells and whistles. I’ve been led down this path by evidence. The journey has forced me to let go of a lot more than I’ve been able to add." - Josh
In investing, complexity is not value added. It's the opposite. I always meet people that tell me the strategy I follow is too simple. But the reason it performs well is exactly because it’s simple. Very few moving parts means little data mining bias. Very few trades mean not being fooled by noise. Being systematic means little room for opinions or emotions.

2. The Power of Doing Nothing by Brett Steenbarger
In trading, doing nothing is often the most difficult doing.  A bias toward activity gives us an illusory sense of control, when in fact we often exercise the greatest control when we are not doing.” - Brett
This year had the most amount of frantic market chatter as I’ve ever seen. The January rout. Brexit. Trump. And all throughout it, I did nothing. Despite all the noise, the markets (and my portfolio) are in the green this year. Many others didn't fare so well

3. Learning to say “I Don’t Know” by Barry Ritholtz

One of the best feelings is when someone asks me where the market is headed and I reply “I don’t know.”

The beauty of trend following and momentum investing is that we simply align ourselves with market forces. We don’t question those forces. And we certainly don’t know what those forces will look like in the future. This frees up considerable mental energy to enjoy life.

4. What You Should Focus On by Michael Batnick

Instead of making predictions about the future, focus on what matters and what you can control.

5. Are 3-year track records meaningful? by Corey Hoffstein

Any active strategy will inevitably have a period where it underperforms its benchmark. This period can last years and thus it is not very meaningful to evaluate a strategy over a less than 5-year period. Yet investors (both retail & institutional) keep focusing on short-term results and is ultimately what leads them to abandon the strategy or fund manager.

6. Permanently Bearish Commentary by James Osborne

While it's popular to be bearish, the world will keep getting better in the long run

7. Case for momentum in Expensive Markets by Jake

It’s easy to look at current stock market valuations and become bearish. But we all know that an expensive market can become even more expensive. Trend following (and momentum) help us stay in a bull market right until its end.

8. Diversification Will Always Disappoint by Cory Hoffstein 

We know that stocks give us the highest risk premium. But holding them alone results in too much volatility. Adding bonds to the portfolio reduces volatility without sacrificing an equal amount in returns. It’s why diversification is called “the only free lunch” in investing. Or is it?

Consider the traditional 60/40 diversified portfolio. During stock bull markets, the bond component is a drag. During stock bear markets, the stock component is a drag. It’s much like driving a car with both gas & brakes applied: When you want to move forward, the brakes hold you back. When you want stop, the gas keeps you moving.

Trend following & momentum are a better diversifier. By investing fully in stocks only when they are in an uptrend or “strong,” you reap their full benefit without the bear market side effects.

9. Why Technical Analysis Gets a Bad Rap by Michael Batnick

Technical analysis (TA) is the study of market prices to gauge supply & demand. When prices are trending “up,” buyers are in control and you want to be long. There are two main branches of TA: pattern analysis (charting) and quantitative (eg. Momentum, moving averages, etc).

TA gets a bad rep when people use charts to make predictions and perform exotic analysis (eg. “doomed-house-and-3-peaks pattern will cause big crash”). It also gets a bad rep when people use complex and tuned parameters in quantitative systems (eg. “Buy when the 23-day exponential moving average crosses above the 64-day average”).

10. What You Should Remember About the Markets by Gary Antonacci

Investing is simple, but not easy. To be successful in the markets, you need the discipline to follow a proven method unwaveringly.

11. Ten Things I Believe About Investing by Ben Carlson

Ben generates quality content daily. I could easily list a more of his posts but I’ll keep it to the one above and this next one:

12. You Have to Invest by Ben Carlson
Yes, risk exists in the markets. It’s never going to be easy. But the alternative for stepping out into the unknown is the known of never building your wealth. Don’t invest. Don’t save. Allow fear to control your financial decisions. Stay far away from the markets. That’s a great way to ensure that your future self will hate you.” - Ben

Happy holidays and see you in the new year!

Friday, November 4, 2016

We Are Not Always So Rational, Part 4

A quick recap: In part 1 & 2, we discussed several cognitive & emotional biases that we suffer from, as well as where these biases originated from. In part 3, we looked at the impact of our biases: on ourselves, our portfolios and on the markets.

I had a reader (Nick de Peyster) leave a comment recently that “investing is about 25% knowledge and 75% dealing with emotional and cognitive biases.” I agree.

In this fourth and last post of this series, we discuss ways to minimize the damaging effects of our biases. Other than the post on compound interest, this is one of most important topics in investing. There are a lot of items discussed here and I will likely touch on them again in more detail in the future.

Minimizing the Impact of Our Biases:

1.  Be Self-Aware

Source: hubpages

Managing yourself begins with knowing yourself. We all have a different risk tolerance and different set of behavioral biases. Learn the types of common biases and determine which ones you suffer from. This series of blog posts can be used as a starting point.

Remember, if your biases are mainly cognitive – they can be fixed through education. If your biases are mainly emotional, then read on.

2.   Be Evidence-Based

Source: pinterest

You can be a passive, value, quality or momentum investor – that’s not the point. The important thing is that you prove to yourself with sufficient evidence that your approach is sound and robust. And do not simply rely on conclusions of others. When your strategy is undergoing that inevitable period of under-performance, you are more likely to stick with it if you understand the strategy thoroughly.

It is recommended that you: 
  • Research and formulate a simple strategy. The simpler the better
  • Gather quality data over a sufficiently long time-period, covering different market regimes
  • Perform back-testing to determine if the strategy has significant outperformance while being cognizant of data mining bias
  • Perform stress-testing to check for robustness (eg. are the results highly sensitive to changes in the model’s settings?)
  • Seek out contrary opinions to reduce confirmation bias. Perhaps there is something you missed in your analysis

3.  Be Systematic

Source: clipartkid

We are increasingly seeing the world become more systematic, from computers marking English essays to self-driving cars. As an Electrical Engineer who worked on developing automation products, I think this is a great thing. Machines, if programmed and maintained properly, typically perform tasks with higher accuracy, efficiency and consistency than humans.

So whatever your investment strategy is, it must be systematic. The less you have to think or do, the better. This not only ensures consistency, but it allows little room for your emotions to interfere. 

4.  Optimize For Your Biases

I used to believe that the Sharpe Ratio (ie. risk-adjusted returns) was what you wanted to maximize. I even named this blog after that term. But this approach is only true if we're robots. For humans, choosing a strategy or asset allocation that deviates from the "optimal" (highest SR) is a perfectly reasonable decision if it reduces your anxiety and is something you are likelier to stick with for the long haul.

So even though I believe a systematic trend following approach is the best for me personally, many have emotional biases that will not realize this no matter how much you educate them. For these types, a passive approach may fit their personality better. While not optimal, it is better than not investing at all.

Another approach is to use pyramiding. For many, investing in one strategy (even if it is robust and sound) can be nerve wracking: either too conservative or too risky. They may instead want to layer their portfolio. The majority of their portfolio can be in the optimal strategy, while the rest can either be in something conservative (eg. a 30% allocation to bonds) or aggressive (eg. a 5% allocation to individual stocks). 

5.  Live Healthy

Source: Vegansoceity

Studies have repeatedly shown that nutrition, exercise and meditation are the most effective ways to reduce stress & anxiety, improve sleep and boost self-esteem and energy levels throughout the day.

Nutrition – Most of us skip meals or reach for junk food during times of stress, but this is right when the body has a higher need for nutrients such as vitamin C and many B vitamins. To make matters worse, feeding our sugar craving may give us that quick burst of energy, but it is short-lived and usually followed by an even worse slump in energy (link).

There has been overwhelming evidence demonstrating the power of plant-based foods: greens, fruits, spices, beans, nuts and seeds. And it goes beyond just reducing stress. Dr. Michael Greger, author of the best-seller “How Not to Die,” shows the scientific evidence of how plant-based foods can prevent and reverse the 15 top causes of premature death, such as heart disease, diabetes and high blood pressure. The easiest and most delicious way to incorporate these foods in your day is with a smoothie. A good blender is the best investment you can make.

Exercise – All forms of exercise help the brain release endorphins and serotonin, triggering a positive feeling in the body. One study found that those who exercised at a moderate intensity for 40 minutes, 3-5 days per week experienced the greatest mood-boosting benefits. So get out and go walking, cycling, yoga or doing strength training.

Meditation – Studies have shown meditation to reduce stress, improve your ability to concentrate, lower blood pressure and boost your immune system.

The focus of meditation is to bring you into the present moment, to quiet an overactive brain and even to reflect on things you are grateful for. Sit with a straight back, practice breathing deeply, and try some background sounds. Be patient & committed and you will find over time that your focus will improve. I highly recommend a guided meditation app called Calm (Apple, Google).

6.  Go On An Information Diet

Thanks to our smartphones and social media, we are now bombarded with information more than ever. And not the information found in books or long articles but:
  • Endless social streams with just a few snippets of words at a time
  • Financial apps flashing ticker quotes in real-time from the palm of your hand
  • Financial media trying to convince you that the next crash is around the corner

How can any of that be good for us?

Author Rolf Dobelli has an excellent article titled “Avoid News: Towards a Healthy News Diet.” In it, he talks about how: 
  • News is to the mind what sugar is to the body. It gives us short-term excitement
  • News is toxic – panicky stories spur the release of cortisol which deregulates the immune system 
  • News misleads us, is often irrelevant and even manipulative
  • News makes us passive, distracted, inhibits thinking and kills creativity 

I highly recommend reading Dobelli’s article. Then go on an information diet: turn off CNBC, reduce the apps on your phone and check your portfolio infrequently. You’ll notice you will have more time, less anxiety and deeper thinking.

7.  Have the Right Mindset

“Patience you must have my young padawan” - Yoda

Despite our best laid-out plans, its easy to get caught up in the latest headline and be tempted to override our system. Being firmly rooted in the following beliefs will help:

  • On average, making impulsive portfolio decisions have significantly hurt investor returns (see part 3 of this series). Do not be fooled into thinking it will be any different this time. Any trade decision that is not backed by a logical, evidence-based approach is not worth taking
  • Your ability to stick with a plan is more important than the plan itself
  • Real wealth accumulation happens over the long-haul, through the power of compound interest
  • Stocks have historically been the asset class paying the highest risk premium. Your goal as an investor is to be invested in stocks as often as possible and only switch to bonds through a systematic risk-management process.

8.  Consider A Human Advisor

Source: Carl Richards, The Behaviour Gap blog

A financial advisor’s main job is to prevent you from doing irrational things with your portfolio.

I mentioned in item 3 above that many tasks are now being automated and that this is generally a good thing. One area that recently exploded in growth is the robo-advisor space. And its first real test came this summer during the Brexit craze. You may have heard that industry giant Betterment locked down accounts to prevent clients from irrationally liquidating their portfolios. While this was well-intended, it may not have been as comforting as talking with a human advisor.

What sets a human advisor apart from a robo is their ability to communicate, to listen, to empathize and to care.  This personal connection is more comforting during times of panic.

Human advisors can also help you with item 1 above: to be self-aware. They give you regular risk tolerance questionnaires and personal assessments to help you understand yourself better. They can also help with educating you on any cognitive biases you may have. 

Further sources

There are too many excellent books, articles, podcasts and videos going into detail on the various topics we covered in this 4-part series. Some of the ones to consider are listed below. Enjoy!

  • Thinking Fast and Slow by Daniel Kahneman. Dr Kahneman is a psychologist that won the nobel prize in economics for his work on decision-making. He is considered to be the father of Behavioral Economics, which challenges the assumption of human rationality prevailing in modern economic theory.
  •  Predictably Irrational: The hidden forces that shape our decisions, Dan Ariely. When it comes to making decisions in our lives, we think we're making smart, rational choices. But are we?
  •  Sapiens: A Brief History of Mankind, by Yuval Noah Harari. If you want to know more about how biology and history have defined us, read this excellent book
  • 10% Happier: How I tamed the voice in my head by Dan Harris. The author discusses how he stumbled upon an effective way to rein in the voice in his head, something he always assumed to be either impossible or useless: meditation.  a tool that research suggests can do everything from lower your blood pressure to essentially rewire your brain
  • The Behaviour Gap: Simple ways to stop doing dumb things with money by Carl Richards. The behaviour gap is the distance between what we should do and what we actually do. The author gives great advice on how to prevent emotions from getting in the way of smart financial decisions.

  • You are not so smart podcast by David McRaney. David has done over 80 podcasts, with each episode focusing on a unique behavioral bias. Oh and every episode ends with a cookie recipe, so there’s that.
  • Masters in Business podcast – interview with Daniel Kahneman. Highly illuminating discussion with the father of Behavioral Economics

  • Overcoming Behavioral Biases Through Mindfulness Training by Dr. Ulrich Kirk (CFA Institute, 4th video in the playlist)
  •  Mind over Money, PBS Nova. Explores why we so often make irrational financial decisions and how our emotions interfere with our decision-making. Entertaining!
  • Boom Bust Boom, a documentary that “guides us through the history and the nature of the economic boom-bust cycle and why people repeatedly ignore it to their sorrow” - IMDb


The End. Thanks for reading!