How to Trump the Buy and Hold Strategy
Top 5 of the Week of February 19
In our Top 5 this week, Nicolas Rabener from Factor Research uncovers the ugly truth surrounding factor investing’s beautiful theory. Of Dollars and Data’s Nick Maggiulli reveals the rule which beats buy and hold investing. And Corey Hoffstein, on his Flirting with Models blog, discusses finding the right balance as a factor investor.
Pedro Barroso, writing for Enterprising Investor, cautions us about market timing for maximum returns. And Collaborative Fund partner Morgan Housel examines the science behind incentives…
The Theory Is Sound, But the Truth is Ugly
- The theory behind factor investing is beautifully backed by substantial empirical evidence, plus it can be utilized by all investor types across markets and different asset classes
- In reality though, that research is founded in backtesting, which is rife with inherent biases
- On top of that, investors are also charged a wide range of fees to access any returns
How to Trump the Buy and Hold Strategy
- It’s possible to outperform the classic buy and hold strategy “if you follow the money”
- Put simply; this is an easy trend following rule to adhere to—you’re simply anticipating mass investor behavior and acting on the information
- Such information can give you an edge against mitigating losses, allowing you to outperform
Trend following: outperformance or not really profitable? Share your comments in the section below
Finding the Right Balance
- Factor investing aims to strike a balance between specificity and generality through value, momentum, defensive, carry, and trend
- Because if a model is too specific, we lose our diversifying capability, and if it’s too general, we lose strength
- It’s important to find the right balance; diversification helps mitigate factor portfolio risk, while imprecision raises risk level due to the introduction of unintended bets
Predicting Returns and Market Timing
- In studying the time-varying volatility on momentum (for how to gain exposure and avoid its crashes), it’s been shown that the volatility of the strategy acts quite predictably over lengths of time
- The controversy behind this risk-return trade-off is that higher volatility tends to lead to higher returns, however, in the case of momentum, higher volatility leads to lower expected returns
- Conversely, the Sharpe ratio of investing in momentum is highly predictable—using a naïve momentum strategy based on this has lead to almost double risk-adjusted returns with less crash risk
It’s Not What You Know, But How You Behave
- There is a science behind how we all respond to different incentives; fixed rewards are too minor to get excited about, but changing rewards offer slightly more stimulation
- It is variable interval rewards though that create a rush of dopamine so addictive that they’re at the root of most gambling devices
- Investing in the stock market is one of the largest examples of variable interval rewards when the rush of returns often overrides any sound judgment
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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