The Art of Streetplay

Sunday, December 18, 2005

Responding to a comment; model building thoughts

I'm not quite sure how but a comment by one of my readers somehow evaded me until now. I thought it might be of value to post some thoughts in response.

I would first of all emphasize how extremely basic that article is, and some of the major caveats which might be of value to consider. I'll walk through it a little.

"Step 1. Decide on the time frame and the general strategy of the investment. This step is very important because it will dictate the type of stocks you buy."

While this sounds stupidly simple, it's surprising how often it isn't adhered to, directly or indirectly. As investors, we are subject to a wide range of psychological biases which cloud our ability to make rational investment decisions. Quite a few of them revolve around irrational response to unexpected events... which can have pretty dramatic repercussions on all aspects of our investment making process, including time horizon. I think a lot of this can be dealt with by thinking a little more deeply about the assumptions underlying the investments we make, which I wrote about a while back in Assumptions Management. I can't stress enough how important I think it is to come to grips with the assumptions we are making when we invest in the companies we invest in-- if I fix my time horizon at six months, does that imply I'm willing to stomach any and all price movement in between? Why? Might it be of value to consider risk re-evaluation points so that you can adapt to the changing underlying fundamentals of the companies you've invested in? If so, what is a logical structure for those re-evaluation points-- a function of time? A function of the influx of news? Quarterly, after the release of the latest K or Q? Could one also deal with adaptive conditions by making shorter term forecasts so that, should negative residuals appear, you could go in and figure out why reality deviated from expectation?

More fundamentally, why will my strategy do any better, risk-adjusted, than the market in the long run? If I know that it can't, then why do I believe that it can outperform over the short run, and how do I know when to switch out because my system has stopped working? If I can't answer all these questions with some degree of confidence, I think one is probably making an uninformed investment decision.

"If you decide to be a short term investor, you would like to adhere to one of the following strategies:..."

This is somewhat silly. First of all "momentum trading" and "contrarian strategy" are two sides of the same coin. The author is referring to autocorrelation trading, or the identification of companies whose price processes tend to be serially autocorrelated with past price movement in some form under a certain set of initial conditions. Yes, autocorrelation can have a positive coefficient (trend following) or a negative one (mean reverting, aka contrarian). Great.

While a lot of short term trading is autocorrelation based, this isn't the case for all short term trading, unless one greatly expands ones definition of "autocorrelation" to include a lot more than past price history. I know very little, but I can assure you that these are two of many, many other forms of short term trading.

"Step 2. Conduct researches that give you a selection of stocks that is consistent to your investment time frame and strategy. There are numerous stock screeners on the web that can help you find stocks according to your needs."

I am surprised that steps 1 and 2 have made no mention of historical backtesting of some form or another. Again, I think this comes back to two of the pillars of investing IMHO-- risk exposure and investment assumptions. Different investment methodologies expose us to different forms of risk. Do we know exactly what risks we are exposing ourselves to, and is there a reason why we want to be exposed to them? Even if I have run all the statistical tests in the world and all seemingly indicate that I am looking at a sustainable chunk of alpha, is there no way in some state of the world for that relationship to not hold in the future?

Let's say I'm looking at Greenblatt's magic formula. Its generated some great returns on a risk adjusted basis over the past couple decades. As an individual investor looking to invest my retirement savings for the next 20 years, what sort of things should be running through my head? One possible concern is that given the increased exposure this strategy will get, a large following of individuals will pile on. ETF's will be created which will do the same. If the investment management business were to universally believe that this will generate alpha relative to straight investment in the S&P, then would the marginal buyer, the guy who gets in after everyone else has bought, expect to outperform as well? One of the sad things about many if not all short term trading strategies is that they are only valuable if no one else knows about them and you are able to trade without creating any footsteps.

But there are more concerns. Let's say Greenblatt's formula became extremely popular. At some point, would it be unheard of for companies to tailor their financials to attain better ranking, even if this didn't accurately represent underlying financial reality? While this sounds like a silly concern, I can guarantee you that hordes of companies are doing exactly this in some way shape or form-- window dressing, tailored compensation schemes, ...

"Step 3. Once you have a list of stocks to buy, you would need to diversify them in a way that gives the greatest reward/risk ratio (The Sharpe Ratio). One way to do this is conduct a Markowitz analysis for your portfolio. The analysis is from the Modern Portfolio Theory and will give you the proportions of money you should allocate to each stock. This step is crucial because diversification is one of the free-lunches in the investment world."

This is a whole other topic of its own and is typically used by quants. Again, we are looking at risk... except now it's portfolio risk we're dealing with. We all deal with portfolio management to varying degrees. The only point I'd make about Markowitz has to do with stability. Markowitz optimality is only as good as the assumptions underlying that optimality. Just because a portfolio historically had a certain risk/reward profile doesn't mean that it will continue to have that into the forseeable future. Thus stability becomes important as a measure of just how realiable the past data is.

One insight about Markowitz portfolios for example is that historical risk happens to be a better indicator of future risk than historical return and future return. Knowing that, I would heavily discount a portfolio whose performance as defined by some measure of risk adjusted return like Sharpe if it is driven by return. I would also then perhaps choose portfolios which as a pre-condition jive with my risk tolerance, because I know I can trust historical risk to some degree, and then spend the bulk of my time assessing the expected return of the stocks in my portfolio.

The most true line in that article, IMHO, is the one below:

"Stock picking is a very complicated process."

Hope this helps.


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