Hi Guys,
I’m sure most all MFO members are at least vaguely familiar with the Heisenberg Uncertainty Principle (HUP). The HUP was postulated by Werner Heisenberg, a German physicist when exploring quantum mechanics phenomena.
In overly simplistic form, it essentially states that when making any measurement, the act of doing the measurement itself perturbs the basic character (real position, velocity) of the particles it is sensing. Hence the discovery process has its own limitations, and some residual uncertainty of the real world condition always remains. The probe influences the behavior of what is being observed.
What is true in quantum physics is equally true in the investment universe. How many times have we been exposed to a revelation that proclaims a fundamental understanding of “What Works on Wall Street”? The answer is “too many times”.
The studies that generate these exuberant claims are usually outcomes from honest research. But far too often they are the product of an excessive data mining operation. If not that explanation, the discovery benefits are muted by an efficient and dynamic marketplace that adjusts and adapts to the new insights to confine its excessive rewards. Persistent excess returns success is an elusive goal.
There are endless real world experiences that illustrate this muting effect. What works for some periods, fails to work for other timeframes. Change happens. Whenever I get to thinking about this topic, my mind always recalls James O’Shaughnessy’s excellent research that was finally published in his 1997 book “What Works on Wall Street”. The subtitle of that volume is “A Guide to the Best-Performing Strategies of All Time”.
In his final chapter, O’Shaughnessy recognized that market preferences are dynamic and he recommended long-term investment policy rules using more than a single strategy. He endorsed multi-factor models with high relative strength ratings. The fundamental stock characteristics that lead to his high relative strength criteria were high Return of Equity, positive 5-year Earnings per Share growth records, and low Price to Book ratios. The carefully researched and fully documented results looked very promising.
That was the research; in short order, real world out-of-sample application of the findings produced dismal outcomes. O’Shaughnessy organized a mutual fund complex (the Cornerstone fund family) that selected its portfolio based on his concluding observations. For years that fund operation underperformed the equity marketplace benchmark in spite of its back-tested pedigree. He eventually sold the funds. It’s interesting to note that the surviving operation recovered somewhat in subsequent years. O’Shaughnessy still manages money and is an antagonist against the random walk market theory. Indeed, persistent performance is an elusive target.
Another prime example of a marketplace prescience reversal is Value Lines famed research analyst Sam Eisenstadt. Value Line’s research king dominated their stock assessment methods since 1946. His winning evaluations were sold to the public for decades until they stopped working. He tried modifying his system, but failed to recover his former deft-hand. He was fired in 2009. Things constantly change.
A rapidly devolving actively managed mutual fund performance record is not uncommon either. After much success, I particularly remember the multiyear underperformance of Robert Sanborn in managing his flagship Oakmark fund. I was an unsatisfied owner in the late 1990s time period. More recently, Bill Miller of Legg Mason joined the ranks of the fallen fund heroes. These guys never did recover their earlier mojo. One persistent lesson is that what worked yesterday might not work tomorrow.
The long history of investment and trading strategies is littered with just such episodes. The discovered mechanical techniques (either technically and/or fundamentally based) work for some periods, but fail for other cycles. That’s why examining a performance record over numerous market cycles is so very important. That’s why some data must always be held in reserve to acid test a purportedly superior formulation to validate its robustness. Even clearing this hurdle does not guarantee a successful race. Markets and investment preferences constantly evolve.
So, one size does not fit all folks for all times. Flexibility of thought and action are guiding principles not to be ignored for successful investing. There are always lessons to be learned.
In that sense our investing procedures should be more like the British philosophical tradition than like its French equivalent. Mimicking Bacon and Locke and Newton, we start by collecting experimental data and formulate a tentative program that may require continuous revision as more data is accumulated. We do not construct a portfolio based on some unverified meta-investment philosophy (like earlier French philosophers) that is not grounded in hard data. We must understand our current beliefs, but recognize that they are subject to transformations to reflect market disruptions.
I find it amazing, and just a little annoying, how often our viewpoints and positions on important matters get distorted, sometimes accidentally, sometimes purposely. Our positions are damaged from incomplete representation. We are forced to muddle our way through these muddied waters of misrepresentations. That is a black-hole time sink.
This happens to everyone, both to the famous as well as to the hoi polloi. An excellent illustration of this phenomenon is attached to the most repeated quote credited to French philosopher Voltaire.
Voltaire purportedly said: “I disapprove of what you said, but I will defend to the death your right to say it.” A very courageous and enlightened statement.
But Voltaire did not assert it. It was invented by Evelyn Beatrice Hall when she completed a biography of Voltaire in 1906. The false attribute has persisted over a century.
In spite of our best efforts to be explicit, false attributes and erroneous interpretations of each of our writings also persist over time. Such are the hazards of composing any semi-controversial position paper. The attributions, incompletely pirated, are often crudely selected partial presentations of our overall position, or are often taken out of context.
Positions and opinions, especially in the investment world, are never fixed in concrete, but rather reflect the current economic environment, current investor preferences, and current investor sentiments. All these factors are in continual flux and influence temporary investment decisions.
Amateur investors, world class professional investors, and economists alike recognize the dynamic nature of investing. Perhaps John Maynard Keynes said it best: “When the facts change, I change my mind. What do you do, Sir?”
Also, Lord Keynes observed: “ Successful investing is anticipating the anticipations of others.”
There is little controversy that Keynes authored many fine quotes. They are as prescient today as when they were first stated over 50 years ago. But even these are subject to improper representation. Keynes is usually remembered as a big-time, unreserved government spender. That’s not entirely correct. It’s a valid representation under many scenarios, but false under other conditions. His opinions morphed over time, and were situational and circumstance dependent. He changed his opinions if the facts dictated that action.
We too all explore, adjust, adapt, and adopt to ever evolving conditions. That’s the ticket for investment survival.
The willingness to alter a plan demands flexible thinking. That’s especially a truism in the investment universe where sentiments change even under static economic conditions. It’s a wild ride, but we will survive.
Best Regards.
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