Thursday, June 25, 2015

Cycling vs. Investing

You might be thinking what these two things can possibly have in common. Let me explain.

Here in Vancouver, we're becoming obsessed with biking. There are over 400 kilometers of bike lanes in the area and half of all trips now consist of walking, biking, or transit.

I got sucked into this culture. It's been about three months that I've been proudly biking to work every day. However, I’m very ashamed to admit that for the first little while, I kept my bike fixed in high gear.

This city has a lot of hills. I loved the high gear as I went downhill or on a flat road. But going up-hill in this gear was painful. I used to always pedal standing up and was completely out of breath by the time I reached the top. Everyone else seemed to be riding the same hill seated with ease and so I wondered why I could be having such trouble.

After some research, I found the answer. Whenever I was going downhill or on flat road, I kept in my regular high gear. But when I was going uphill, I downshifted to a low gear. Magic. What a painless ride.

The same concept applies to investing. You can’t be holding the same fixed portfolio allocation in both boom times and in recessions. You need to occasionally shift gears between stocks and bonds depending on the prevailing environment. And just like with cycling, the method to switch gears should be very simple and systematic.

However, the common mantra in the financial industry is that you must hold a fixed allocation to stocks and bonds regardless of the market environment. Most advisers and fund managers love to hug the benchmark indices. Finance textbooks told them that the market is efficient and they should not try to beat it. In addition, they want to minimize their “career risk.” This is the risk of their customers abandoning them if the fund has a period of under-performing the benchmark.

Then every so often, a recession hits and these "experts" and their unaware clients get tortured through it. Just like I suffered biking uphill in fixed gear, but worse. Thankfully, it doesn't have to be this way.

Sunday, June 21, 2015


Hello and welcome to my blog.

I thought I'd write this post to introduce myself and outline what this new website will be about.

Who am I?

Contrary to what my friends tell me, I am not a robot that is becoming self-aware. My name is Gogi Grewal and I'm from Vancouver, BC. I wrote a brief bio about myself and my personal investment journey. Please be sure to read that in the About page.

What is this blog about?

Investing. I know this topic is highly broad and often intimidating, confusing and downright boring. But my goal is to simplify it by discussing only relevant areas in plain English. There will be the odd post that will be heavy with numbers, put I promise to keep that to a minimum.

Here's a brief outline that I have in mind for this blog:

  • Basics - Any discussion on investing needs to start with a solid foundation. I will discuss the power of compound interest and why you need to start investing immediately, the concept of risk, the 5 major asset classes, and the myriad of investment products available today.

  • Human behavior - This is a very important area of discussion. When it comes to investing, our lizard brains really are our own worst enemy. How often do our emotions cause us to buy and sell at exactly the wrong times? What is happening in our brains when we gain and lose money? Behavioral biases such as anchoring, herding, and the disposition effect contribute to the markets being less than efficient. We will show this with examples from history.

  • Strategy - If markets are not efficient, what is the best way to actively invest? While my focus will be on momentum investing, I will describe other types of active strategies (eg. value, macroeconomic, charting, etc) to show why momentum stands out from the pack. I will also discuss back-testing basics and the importance of simplicity and diversification in investing. 

  • Execution - This is everything that comes after developing a sound investment strategy. It includes: the importance of self-discipline & patience (arguably the hardest part about investing), tuning out the news, minimizing costs, selecting an online broker, tax tips, and useful software & websites. 

You can also get a sense for what this blog will be like by looking at my bookshelf page.

Is that a typo in my blog name?

The word "Sharpe" comes from the term "Sharpe Ratio." This is simply a measure of an investment's risk-adjusted return and has become a standard measure in the financial industry. So our name Sharpe Returns is just some clever word play :)

Finally, why did I start this this blog?

This is a place to organize my thoughts, keep a diary of my continuing investment journey, record any good articles and books I find, and hopefully provide value to my readers along the way. As this is a brand new blog, I welcome any feedback on ways to improve it.

Thanks for visiting this site and hope you enjoy it.


Friday, June 19, 2015

The Philosophy of Momentum

What is momentum and why is it so pervasive? This is something I think about a lot.

Momentum in Everyday Life

First off, momentum is the tendency for something to continue in the short-term doing what it’s been doing. It’s Isaac Newton’s first law, which applies to all physical objects having a mass and velocity.

When we are driving a car on a flat road and take our foot off the gas pedal, the car continues to move forward for a certain period of time. When a train is approaching a station, the operator needs to apply the brakes well in advance since the train wants to keep pushing forward. When the captain of a cruise ship sees the ship is heading in the wrong direction, it takes a while to change course. These are simple examples of momentum as applied to physics.

Momentum not only applies to physics and financial markets, but life in general. Dorsey Wright pointed out:

"Momentum is pervasive, both in the financial markets and in life in general. Andre Agassi found that past decisions created a momentum-effect in his life that made it very difficult for him to change course."

Think about your career for example. You spend a lot of time going to school and then gaining experience. Once you get good at a job, you have momentum. Trying to make any career path change at that point is slow since it often takes a lot of time and effort to get good at something else.

I recently started going to a local cooking workshop that is held in my area once a month. The organizer was telling us how it took a lot of effort initially to find a venue with a kitchen, volunteers, come up with workshop ideas and then build up a sizable attendance. "But now that we've been doing this for two years, it has gained momentum. People just show up without us having to do any advertising."

Another example is with car traffic. Suppose you are driving on a highway with two lanes going each way and you need to reach your destination efficiently. You observe for a while that cars are travelling faster in one lane. Without thinking twice, you switch into that lane because it has relative momentum. 

Momentum Investing

Let’s shift our focus to momentum investing. We have seen momentum backtest results going back over 200 years showing its strong persistence. But we need to discuss why this anomaly exists in financial markets and why we expect it will continue.

Blogger Miles Dividend recently wrote a nice blog post looking at this very topic. He says that from an individual investor’s point of view…

"…momentum is simply human beings’ inexorable tendency to chase performance. Think about the first time you had to make an investment decision. What did you look at first? I’m guessing that one of the first things that you were drawn to, like a moth to flame, was the past performance for the various funds listed. I know that was the case for me."

In Dual Momentum Investing, Gary Antonacci of Optimal Momentum has a whole chapter dedicated to human behaviour. Gary shows that behavioral biases (such as anchoring, herding, and the disposition effect) can cause stocks to underreact on a short-term basis and overreact longer term. It takes time for investors to realize what’s going on, seeing their friends & neighbours getting rich, before they feel compelled to jump in too. The market builds momentum, as price gains beget even more price gains. Even Isaac Newton, the father of momentum, was sucked into the power of emotional biases during the South Sea bubble:

Source: Jeremy Grantham, GMO, “On the importance of asset class bubbles,” Jan 2011

Momentum investing works not only due to our individual behavioral biases, but also because of the way large fund managers, businesses and economies operate.

Miles discusses fund managers by saying:

"...on an institutional level transactions occur much slower as funds move away from losing funds and towards winners. This latency is caused by the inherent cost of moving large sums of money, and the constraints on moving large amounts in and out of funds."

I can elaborate on this by saying that it takes time for economic data to be generated and for fund managers to react to that data. On top of that, fund managers need to slowly build or liquidate positions so as not to affect price and hence get the best trade execution. When large positions are being built, this causes a basing/accumulation phase. When large positions are being liquidated, this causes a topping/distribution phase. The chart below depicts this and is the main concept behind what is known as the “Wyckoff Method.

The exact same reasoning can be used to describe momentum seen in large economies. Miles writes:

"When an economy begins shrinking, it takes time to for those in power to recognize that it is in fact shrinking. And when second order actions occur, and interest rates are dropped by central banks, and stimulus bills are passed by governments, it takes time for the pain to work its way through the system, and for the corrective actions to have any effect at all."

I can give a further example of how momentum applies to the way a large company operates. It takes some time for a company’s management to discover any failing business units, take cost cutting measures, improve those units and/or diversify into new ones, and then finally see the benefits of their efforts. Hence, weak companies continue to stay weak in the short-term, and vice versa for strong companies.

Jim Collins, author of "Good to Great" explains the role that momentum plays in getting a company to become successful:

"Picture a huge, heavy flywheel. It’s a massive, metal disk mounted horizontally on an axle. It's about 100 feet in diameter, 10 feet thick, and it weighs about 25 tons. That flywheel is your company. Your job is to get that flywheel to move as fast as possible, because momentum—mass times velocity—is what will generate superior economic results over time. 
Right now, the flywheel is at a standstill. To get it moving, you make a tremendous effort. You push with all your might, and finally you get the flywheel to inch forward. After two or three days of sustained effort, you get the flywheel to complete one entire turn. You keep pushing, and the flywheel begins to move a bit faster. It takes a lot of work, but at last the flywheel makes a second rotation. You keep pushing steadily. It makes three turns, four turns, five, six. With each turn, it moves faster, and then—at some point, you can’'t say exactly when—you break through. The momentum of the heavy wheel kicks in your favor. It spins faster and faster, with its own weight propelling it. You aren't pushing any harder, but the flywheel is accelerating, its momentum building, its speed increasing. This is the Flywheel Effect"

Thus, we see that there are very deep-seated mechanics that have made momentum investing so successful in past centuries and why it should continue being successful. It simply takes time for markets to build a new uptrend and time for it to change that trend. Hence, in the short-term markets continue trending in the same direction. This is largely because of behavioral biases and the natural lags between when large fund managers, businesses and economies discover a change is needed and when the effects of that change become visible.

History has shown that changing the direction of a giant ship like the S&P 500 took a while. From 1982-2000, 2003-2007 and 2009-Present, US stocks went in one direction: Up. Before the 2000-2003 and 2008-2009 bear markets, it took over a year-long topping formation before the market changed course. It’s for this reason that momentum investing and trend following in general works.