Out-Of-Sample Testing: Not the Be All and End All
Top 5 of the Week of July 10
In our Top 5 this week, Gogi Grewal of Sharpe Returns walks us through the basics of asset allocation. A Wealth of Common Sense’s Ben Carlson explains why knowledge isn’t everything. And Nir Kaissar and Barry Ritholtz debate knowing when stocks are properly valued in a Bloomberg post.
Michael Kitces, in his self-named blog, looks at the real reason behind the rising popularity of ETFs. And Alvarez Quant Trading’s Cesar Alvarez examines the gray areas in out-of-sample testing…
A Beginners Guide to Asset Allocation
- Asset classes tend to be split into equities (stocks) and fixed income (bonds)—with diversifying classes in commodities, real estate and private equity too
- History dictates that stocks yield better returns than bonds, and domestic and foreign equities are kept seperately as they experience different risk and returns
- In the 1950s, Harry Markowitz deduced that by adding bonds to an equity portfolio you dramatically reduce volatility without overly affecting returns as they tend to be uncorrelated
Knowledge Will Only Take You So Far
- When it comes to learning, expanding our knowledge will only take us so far, learned wisdom is not the same as practicable skills—this is as true in investing as in any subject
- For investors, this means that improving your financial literacy does not automatically improve your money skills
- It is important to complement your financial education about the latest tactics and strategies with learning on how to make informed decisions
The Fundamental Argument Is…
- Kaissar believes it doesn’t matter which ratio you use, all of them “point to higher stock prices in the U.S.” compared to the overseas market
- Ritholtz believes that “valuation cycles are driven by psychology” and the current situation of performance difference between the U.S. and Europe will turn around eventually
- At its core, it’s U.S. versus overseas valuation and so, a “loosely disguised active-versus-passive debate”
- Either way, diversifying in European indexes won’t steer you wrong
Not in the Job Description
- With the rise of “no-load”—no commission fee—investment products, financial advisors (FA) are less about giving advice and more about portfolio management
- They are leading a move away from mutual funds and reproducing similarly diversified portfolios with ETFs as the building blocks—without mutual fund managers and extra cost layers
- The result: The ongoing rise in ETFs is not an increase in passive investing but in active investment strategies as FAs attempt to lower costs and increase their value
Have you met a financial advisor like this? Share your comments in the section below
Out-Of-Sample Testing: Not the Be All and End All
- When backtesting, we can divide a sample of time series data into In-Sample (IS) and Out-of-Sample (OOS)—the IS data is used to find the strategy and OOS is used to evaluate that strategy’s performance
- OOS testing though can cause issues because past markets vary greatly to today’s, it’s difficult to test for human nature as a factor, and it can lack data
- Also, our knowledge of the OOS time frame can create a bias for the way we test, so we don’t get truly impartial results
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.
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