Studies of Life

Learning by doing.

What’s the most practical investing system?

21 December 2014 by Jim

The more I look into investing systems, the more I feel like it’s all a big game. You can get into it, research strategies and try to beat the market. But in the end, it is hard to imagine that a given system, no matter how well it works in some periods, will be constantly out-performing. When the dirt hits the fan, what will you do? Will you sell when a crash occurs? Or when you underperform by a few percentage points?

Note: I’ve been pretty busy during the past weeks, and now the holiday’s are coming. I wish everyone a merry Christmas and a Happy New Year full of peace, success and freedom from worry. “Schéin Chrëschtdeeg”, as people say in my home country!

If you’re reading about how to invest, you’re probably not yet fully certain that your strategy is the best, and you may change your portfolio constantly. But that’s not a good thing to do.

First, you obviously incur transaction fees if you trade a lot. Second, you may later on blame yourself for selling or buying some issue too early or too late. All of that is pointless.

That is why the ideal situation would be one in which, after a few years of experimentation, you settle on one strategy and stick to it. All the wonderfully enthusiastic strategy profiles with specific Sharpe and Sortino ratios, variance and Maximum Drawdown metrics are nice, but in order for a strategy to make a difference to you personally, you need to stick to it. This single sentence is among the most important that any person can learn, and I don’t mean “remember” but learn as in “understand and apply because you know it’s the right thing in your own head”. And it’s difficult to stick with your strategy, especially if a lot of what you own is invested in the stock market, as it is in my case.

We have already talked about the Permanent Portfolio, a very simple portfolio with 4 ETFs, each of them representing 25% of the total value of the portfolio. This strategy has performed very well in the past. More active strategies that make adjustments more frequently (moving average crossover strategies, or specific stock picking methods like Piotroski‘s filter for example) do work better, according to academic literature, but the fact that they require more involvement on your part also means that they give you more opportunities to stray from your path and make “adjustments”. Maybe you don’t like one of the stocks that the Piotroski filter returned. Or you think that for a short time, it would be good to also invest in a 5th ETF in addition to the 4 of the Permanent Portfolio. You can of course do as you please, but academic research suggests that quantitative systems (i.e. systems based on specific criteria that are blindly implemented without any room for personal judgment) outperform human decision-makers in every area imaginable. The simple use of a checklist can improve medical outcomes tremendously in both developing countries and hospitals in the US and Europe. It makes flying safer because pilots are required to work through checklists as well, and it helps architects make sure that everything goes according to plan. These examples are all from a very illuminating book, The Checklist Manifesto by Atul Gawande.

 

Screen Shot 2014-12-21 at 20.14.59It taught me that even if you think you’re doing it 99% correctly, don’t be so sure. In terms of stocks, forget your intuition. Intuition makes people poor in most cases. Warren Buffet does not use his intuition to choose stocks. He analyses them according to a framework he came up with.

A simple system like the Magic Formula by Joel Greenblatt, although logical and easy to understand, will, if implemented by a robot, outperform over 90% of investors, because most people do not have what it takes to stick to something through thick and thin. The most intelligent way you can invest is to:

  1. get educated about investing so you know how it works and what you’re doing,
  2. choose a system, or a combination of rule-based systems that seem to perform well in tests and are supported by academical or your own research
  3. apply the system religiously, like a robot, preferably using a checklist

Why would you need a checklist if you know the rules of your chosen system? That’s exactly the point. You may know these rules now, but in one year, your memory of them, or their relative importance, may have changed, and you may venture farther and farther from the initial system and adjust it more and more, until it no longer works.

For many people, the Permanent Portfolio, or indeed any long-term portfolio with a simple structure (2 to 10 ETFs with fixed allocations) will be a better choice than individually choosing investments themselves. Even investing in a simple index ETF replicating the S&P500 has performed extremely well in the past 50 years, if only you could have invested right away and stuck with your plan.

It’s not about tweaking a system endlessly, but about choosing one of the many systems that are proven to work, and then sticking with it. Choosing is easy, sticking is hard. Very hard. But that’s the price you pay for exceptional performance.

In many ways, the most practical investing system, i.e. the one you’ll stick with most easily, is the only one you should be interested in. If you’re not sure you’ll be able to stick to a complex system, look for a simpler one. One that doesn’t involve much work on your part. That’s better than choosing a supposedly superior complex system that you’ll stick with for 6 months until abandoning it.

Update January 2015: Since I myself like testing new portfolio strategies, I’ve decided to do so in 2015 and test 6 investing strategies on paper throughout the year to see how they would practically work out for a European investor. I’ll be posting updates every month.

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