How can we tell if the things we do as investors have a net positive impact on our future returns?
When a professional baseball player adjusts their swing, they have a lot of “pre-“ and “post-” data to analyze. Did their On-Base percentage, Batting average, RBIs, and Slugging percentage improve? They can tell, usually within a few weeks, if the adjustments they made are working or not.
Investors are not so lucky.
We can make changes to how we think about risk, what our portfolio allocations are, what information we read — everything that goes into how we invest. Then we wait a decade to see if the changes we made enhanced our fortunes.
In my work, I rely on academic research, statistical analysis, and very select research from the buy- and sell-side, married to three decades of experience observing investors and markets in real time. I try as best as I can to avoid making unforced errors. Most importantly, I rely on a lot of specific methodologies and thoughts about how and what we do when it comes to thinking about investment strategies. A few examples:
1. First Principles: Nothing is more useful than breaking down complex ideas and thorny issues to their most basic levels, and then rebuilding from there. This strips out the usual assumptions and unproven ideas (myths) that might not otherwise be recognized.
2. Oversimplification: The world is a complex place, and it does not serve our interest to reduce this complexity to buzzwords or slogans. Believing that you can know what will happen based on anyone single variable is simply a recipe for disaster. We want to reduce complexity to a manageable level, but not to a point where it leads us astray.
3. Counterfactuals: Always consider what any outcome might have been had the opposite of your underlying premise been true. You will be surprised to see how often this changes your view of the result. How important is “X” if the opposite of “X” yields the same results?
4. Framing: The context we use to look at market action and portfolio performance has an enormous impact on the conclusions we reach.
When I mention that the NASDAQ 100 was up 54% and the S&P 500 was up nearly 25% in 2023, most people’s first reaction is “Wow, that’s too far, too fast.” But tell the same people that returns for both indices over the calendar years 2022-23 were flat – about 0.0% – and you can bet their response is radically different.
Framing matters a great deal.
5. Correlation and Causation: It is so easy to confuse these two, especially when events occur close together in time and space. There are constant examples spurious correlations in markets, and investors need to be vigilant to avoid mistaking coincidental occurrences.
The philosophy of causation is complex, but let’s simplify it. To assess how credit- or blame-worthy any particular factor is regarding subsequent market performance, always consider whether that factor was 1) proximate to subsequent results, 2) created a statistically significant result, and 3) was both necessary AND sufficient for that result.
As I said, it’s complex.
6. Unknowns: Markets, the economy, and investment returns are driven by a complex web of interrelated elements. The short term is simply too random to reliably be predicted. In astrophysics, it’s called the 3-body problem1: The variables created by the interactions of just 3 planets, moons, and stars are simply too chaotic to create a reliable forecast.
Now try forecasting the economy or the stock market with 1000s of factors and millions of people, all reacting to each other. While it might be humbling to admit how little we actually know about what will happen in the future, humility is a vastly superior way to build a portfolio than pretending you can know things which in reality you do not and cannot know.
7. Practicality: The best investment strategy is not the one that produces the greatest returns, but rather, the one the investor can most easily live with.
Wes Gray of Alpha Architect2 created a thought experiment of a prescient fund manager whose quant model relied on perfect foresight in identifying long-term winners and long-term losers. The results were spectacular, but the savage drawdowns were gut-wrenching. He concludes that “Even God would get fired” for deploying such a strategy.
Perfection, as Voltaire3 observed, is the enemy of the good. The same is true for whatever your approach is to managing your assets – it has to be good enough to achieve your objectives, but not so time-consuming, emotionally draining, and anxiety-inducing that it interferes with your ability to enjoy your life.
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FOOTNOTE: Mason Stevens has a short explanation of the issue: “In 1887, Henri Poincare proved that motion of celestial objects (bar a few special cases) is “non-repeating”. Meaning that in a closed-body system, the historical pattern of object positions has zero predictive power in forecasting where the objects will be in the future.”
2. Even God Would Get Fired as an Active Investor
Wes Gray
Alpha Architect Feb 2, 2016
3. Voltaire, who quoted an Italian proverb in his Questions sur l’Encyclopédie [fr] in 1770: “Il meglio è l’inimico del bene”.[2] It subsequently appeared in his moral poem, La Bégueule, which starts:[3] Dans ses écrits, un sage Italien Dit que le mieux est l’ennemi du bien.
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