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It’s all a Big Confidence Trick

Top 5 of the Week of July 31

A Wealth of Common Sense’s Ben Carlson heads up our Top 5 this week with a view on our bias for seeing bubbles everywhere. Jack Vogel, writing for Alpha Architects, reveals how to avoid overpriced winners in momentum investing. And from Evidence Investor, Robin Powell uncovers the confidence trick the fund industry plays on us.

Barry Ritholtz, Chairman & CIO of Ritholtz Wealth Management, examines the disappointment that comes with backtesting in Fundamental Investing. And Resolve Asset Management’s Part 3 of Dynamic Asset Allocation explores the data on how assets produce their momentum…


Bubbles, Bubbles Everywhere

 

  • With two large boom-and-bust cycles in our recent past, it makes sense that many investors are spending all of their time worrying about bubbles and crashes despite them being a rare occurrence
  • True evaluation of bubble potential requires an understanding of human behavior, rather than an examination of economic and market environment factors
  • But today’s environment is difficult, prices are up, but investors haven’t reacted euphorically yet—likely because the Global Financial Crisis is still fresh in our minds

Think a bubble is just around the corner? Share your comments in the section below

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Avoid Overpriced Winners

 

  • Overpriced Winners (OW) or ‘constrained’ momentum stocks here are firms with “high past returns, low institutional ownership, and high recent changes in short interest earning persistently low returns going forward”
  • It appears short-selling constraints lead to an irrational inflation of price despite pessimistic viewpoints which would say otherwise, resulting in this overpricing
  • From an investor’s point of view, it makes more sense though to avoid going long on these types of stocks rather than shorting them

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It’s all a Big Confidence Trick

 

  • The fund industry has a tendency to make a big song and dance about the launch of exciting new funds which are outperforming all the others
  • Which makes sense, but they never discuss those that don’t outperform in quite the same manner—instead, these just get quietly closed down
  • The real song and dance is in being able to identify which funds will be long-term winners, which sadly, no adviser, investment consultant or fund analyst can do yet

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Proceed with Caution

 

  • Fundamental indexing (FI) or smart beta—a mixture of active stock-picking and passive investing—has grown in popularity alongside investor’s recent huge embrace of index investing
  • But FI is coming under crossfire because of the dangers that come with it from backtesting and overfitting performance results
  • Investors expecting strategies to outperform based on backtested data will no doubt be disappointed when the same strategy is applied to the real time market

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Part 3: When to Measure Performance Momentum

 

  • Given the many ways to measure momentum, it is worth exploring if differences in risk and return patterns can affect the final outcome
  • Creating momentum portfolios based on various risk-adjusted return ratios showed similar return outcomes on average
  • The main benefit from the risk-adjusted methods versus price momentum is a lower dispersion in outcomes, hence, less distance between the best and worst test

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Top 5 of the Week is a summarized collection of financial investment articles that we like and think you might like too. Having written thousands of pages of equity strategy and company research between us, we understand the allure of the ever-changing world of finance. Investing is an art form—and like everything, something you can work on and improve at. There are some excellent writers out there on the finance web, some offer a running commentary on today’s market, some are doing research, some have tips on how to Become a Better Investor, and some just lift the cloud of fog behind a lot of financial jargon. Each week we will keep you up to date with the top 5 articles worthy of your attention.


 

Anything you would like to discuss about this week’s top 5? Do you have another favorite that isn’t mentioned here? Feel free to add it below. Let’s start a discussion in the comments section!

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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article. The Become a Better Investor Team doesn’t necessarily endorse any stocks or shares mentioned in the articles or the author of such articles linked to and summarized in Top 5 of the Week and cannot guarantee the accuracy of its information.