I’m a big fan of the Alpha Architect team. What really struck me when I first met these guys is how knowledgable, yet humble they are. Like many quants, they understand the limitations of the human brain, which has led them on their search for evidence-based investing. Nobody pumps out more quality data-driven stuff on a daily basis than these guys.
If you liked Quantitative Value, you’re going to love DIY Financial Advisor. This book busts a lot of myths and empowers investors to take their portfolio into their own hands. Here are some of my favorite bits from the book.
Alpha Architect on humility.
On most discretionary, day-to-day aspects of investing, for example, picking individual stock picks or the direction of interest rates, Wes believes firmly that he is completely wrong almost all off the time, whereas Vic (Niederhoffer) believed he could master the markets. And while an expert with no faith in his or her ability sounds counterintuitive, it is actually invaluable because this approach to being an expert minimizes the chance for overconfidence. In fact, Wes has established internal firm structures to ensure that he is reminded on a frequent basis that he is a terrible expert in this sense. But why would an expert systematically convince himself that he is not an expert? The reason Wes engages in this peculiar behavior is explained in a quote often attributed to Mark Twain, “It ain’t what we don;t know that causes us problems; its what we know for sure that simply ain’t so.”
Alpha Architect on story-based investing
Pigeons aren’t the only animals suffering from story bias. Wes’s uncle is convinced that a Dallas Cowboys victory during the Thanksgiving Day football game is a great signal for the stock market. The logic is as follows: The Cowboys are ‘America’s Team’ and if America’s team is doing well, people are happier and they spend more money….Since the turn of the century, the Cowboys prediction is batting 9/14, or 64 percent. This means that over the past 14 years, when the Cowboys win the Thanksgiving game, 9 times out of 14 the market was positive. This sounds pretty good until you consider that over the past 87 years, there is a 72.4 percent chance the marker is positive. Clearly, the Cowboys indicator is bunk.
Alpha Architect on bottom-fishing
How about the 52-week low stock screen? Many of our stock-picking friends love this screen, thinking that 52-week-low stocks are ‘cheap’, on average, and therefore must offer the potential for great return relative to other stocks in the investment universe. Unfortunately, ’52-week-low stocks are virtually synonymous with what academic researchers call ‘low-momentum stocks.’ Low-momentum stocks, for those who shy away from reading academic finance journals, have been shown to be one of the worst-performing groups of stocks one can choose from.
Alpha Architect on the myth that economic growth drives stock returns
We’re going to let you in on a little secret: Investors focused on economic growth are wasting their time…If anything, the evidence suggests a negative correlation between equity returns and GDP growth…It may be that the best prices can be had in times of low economic growth, whereas we tend to overpay in a growing economy. The idea that strong economic growth translates into strong stock returns is a superstition, and is not backed by evidence.
Alpha Architect on using models
Even if one buys the argument that models can be useful, one might object that models are too limited and cannot be applied in sophisticated contexts like investment decision-making. What, for example, is the algorithm going to say when we face a unique situation the world has never seen? This time is actually different. The story is that the human experts can adapt and create on-the-fly modifications to the model that creates value. This well-trodden, but empirically busted, rebuttal against algorithms is deemed the broken-leg theory and relies on the false premise that humans don’t suffer system 1 flaws.
Alpha Architect on investing systems
The sad conclusion is that few if these ideas stand up to intense robustness tests except for the simplest technical rules (much like asset allocation- simpler is often better). Trust us, we’d love to tell you that we have identified a way to reliably predict the market using fancy algorithms derived from hundreds of academic research articles. We’e replicated these papers in one form or another and subjected their insights to intense empirical scrutiny. We’ve also tried to integrate the signals suggested from the research into a trading model we could deploy in the real world…At the outset, we did mention that simple technical rules- the simplest trading rules out there- are, ironically, the most robust and show the most promise for protecting against significant drawdowns. Granted, these rules are not meant to ‘beat the market’ but rather allow a do-it-yourself investor to manage declines in the market easily and at low cost.
Alpha Architect on value and momentum
Momentum investing may sound preposterous to those who believe in efficient markets. The idea is simple: Each month, rank stocks on past prices and buy the top decile of firms that have performed the best over the past 12 months…The spread between high and low momentum stocks from 1927 to 2014 was 18.43 percent. This is close to five times the spread between value and growth firms.
Alpha Architect on combining value and momentum
Examining the combination of 50 percent value and 50 percent momentum, this portfolio generates even higher Sharpe and Sortino ratios, with a lower drawdown than the market. The correlation between value and momentum is only 68.60 percent, which is much lower than the correlation between value and the S&P 500 (87.54%) and the correlation between between momentum and the S&P 500 (74.15%). This lower correlation gives some diversification benefits when combining the two portfolios.
Alpha Architect on why people might not DIY
Most importantly, let us not forget the qualitative aspects of investment and the value that some place in experience when it comes to finance. No matter what data we may find, or empirical evidence we can produce, some humans will always revert toward an ‘expert’ opinion. A study of 250 seasoned investors determined that approximately two-third agreed with this statement: ‘As a forecasting task becomes more complex and difficult, I tend to rely more on judgement and less in formal, quantitative analysis.’ If the experts leverage judgement and experience, shouldn’t we do the same? Many continue to believe that experts beat simple models. The data certainly don’t support this hypothesis but as Wes’s father used to say on their cattle ranch: ‘You can lead a horse to water, but you can’t make him drink.
Alpha Architect on working with an advisor
Some of us may still prefer to work with an advisor, which makes sense if we know we do not have the mental discipline to adhere to the model. If we do decide to work with an advisor, stick to the FACTS (fees, access, complexity, taxes, search), and remember that simple models can beat experts. Keep asking questions and make sure you understand each position in your portfolio.