Successful investing is analogous to habit formation. They both involve adjusting our evolutionary wiring for short-term reward in place of long-term superior gain. We of course know that forming long-term habits can lead to compounded gain in health, knowledge, and life quality. Of course, habit formation is tough, as is consistent capital appreciation! There’s a cottage industry built around achieving both. Self-help books, diets, meditation retreats, CNBC, Zerohedge. It’s all effectively the same. I spent much of my life thinking the entire field was filled with charlatans and promoters.
Several years ago, I was reading Mark Suster’s blog and came across a post referring to Steven Covey’s 7 Habits of Highly Effective People. Even with my aversion to the self-help aisle, the post nudged me to purchase the audiobook, and I was amazed by how resonant some of the themes were to my career and personal life. Prioritization was one of the key insights. It seems especially important in an increasingly frenetic world. Beginning with the End in Mind was another. I won’t provide the cliff notes to the book here; there are plenty of blog posts that do a good job of it. I would like to expand on these two points as it pertains to successful investing habits.
Successful Habits in Quant Investing
Caveat: I should probably defer to Cliff Asness on the subject and most subjects quant. Now that that’s out of the way, habit formation is particularly important in systematic or quantitative investing. This is partly because quantitative investing strategies engender greater principal / agent risk compared to fundamental investing. By that, we mean that fewer LPs understand the core principles of systematic strategies compared to fundamental strategies. Because of this reality, at periods of maximum pain, there is more skittishness on the part of investors in quant strategies. During periods of stress, they cannot effectively differentiate a broken model from a period of lucrative mean reversion. Some would argue the managers can’t either! As a result, alignment with investors is paramount in quant land, and to develop that alignment requires good habits. If you want an academic explication of this, feel free to read this.
Begin with the End in Mind
In periods of market stress, investors naturally re-evaluate their investments. Hey, after a month like October we did the same with our portfolios! Poor performers increase their likelihood of being culled. This seems counter-intuitive from the overriding market phenomenon of mean-reversion, but it clearly demonstrates the human fight or flight response, as well as the endowment effects present within most hierarchical institutions. These are supernatural forces that can overwhelm any single individual in an organization that allows them (often unknowingly) to blossom.
If we begin with the end in mind — which for active investing often begins with a hypothesis around why a certain active investment should outperform its relevant benchmark (net of fees / tax / etc.) — it often saves us from our worse tendency to second-guess in a moment of panic, our thorough underwriting. Take factor-investing, specifically value investing. The field has had a rough go at it in the last 10+ years, and we (along with every other talking-head) have opined why. In a 2017 paper by quant investing godfathers Eugene Fama and Ken French, the authors say not so fast pundits.
The skinny of the paper is a thought experiment: if we bootstrap the monthly historical behavior (across decades of evidence) for our foundational factors, what is the likelihood of extended underperformance for well-established factor behaviors? The result is shockingly high for extended periods of time. We’re talking 10-year intervals of underperformance. This puts a month like October 2018 in perspective!
What is fantastic about the piece is how the authors start with an all-but agreed upon assumption: equities will outperform cash over the long term. They run about 100,000 bootstraps and demonstrate how extended periods of underperformance for an all-but orthodox held belief (sorry goldbugs) do indeed occur. Does this lead investors to question equity investing? Well, I wasn’t alive in 1933, but the response over the ensuing 80 years has been an emphatic no. And yet we do this consistently with style factors.
The piece first and foremost seems intent on curtailing the endless speculation about what has “caused factor behaviors to change.” Fama and French make a strong statistical argument to equate the recent underperformance of factors such as size and value to an expected outcome, (in the Bayesian sense). If that’s the case, does this mean we need a generational timeline to invest? Do we need to evolve beyond instant reward for infinitely delayed gain?
Not exactly. It means we need to be more honest about our expectations for making investment decisions. Straight and to the right is the goal, but with that comes a cost. Time arbitrage is an effective tool in mitigating that cost, but it comes with strings attached. Those strings are not as simple as infinite patience. Take a permanent capital vehicle. Presumably the vagaries of monthly, quarterly, nay yearly performance should wash over the CIO of an endowment like the soothing pitch of a Tibetan Singing Bowl. But individuals lack permanence, not only in their lifespan but also in their career trajectory. What’s permanent about the endowment is not the case for its investment professionals. Career risk and hierarchical design throw a wrench in this equation. So does the sneaking suspicion in the back of our heads that asks what if this time is different?
Ugly Evolutionary Truths
The ugly truth is that certain factors do get arbed away, and as such, we need to evolve our approach. Pari-mutuel systems are reflexive, and they have a strange way of finding new equilibria when perturbed by things like the advancement of technology. On top of that, Flows influence factors. The most lucrative arbitrages invite competition that extinguishes them. Various naïve strands of trend-following and charting have all-but been exhausted. What seemed like persistent sources of risk premia are now baked into retail trade platforms and poured over in Markets Wizards Books by dorm-room traders.
The key difference is the underwriting of first principles and how this underwriting can deliver persistent results. This brings us back to Covey. He tells us to Put First Things First, which is a polemic on prioritization (say that five times fast). In terms of how we prioritize the understanding our portfolios, we must start with first principles based upon empirical evidence. That is the foundation of factor investing, based on decades of empirical study.
Will these principles require adaption? Most certainly. But if we prioritize a deeper understanding of why and not what, this habit will give us the resolve lacking in those that simply chase returns. Or as Asness says, “If sticking with them [factors] were easy, the threat of them being ‘arbitraged away’ would indeed be much greater, and nobody would take the other side.”
Shleifer A, Vishny R. The Limits of Arbitrage. The Journal of Finance, Vol. 52, No. 1. 1997
Fama E, French K. Volatility Lessons. Financial Analyst Journal, Vol. 74, Issue 3. 2017
Asness, C. Liquid Alt Ragnarök? AQR Blog, September 7, 2018.
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