“We don’t rise to the level of our expectations, we fall to the level of our training.”
Archilochus
Greek Poet and Soldier
“Well, the process is really what you have to do day in and day out to be successful.”
Nick Saban
University of Alabama Football Coach
“Factors carry premiums to reward the losses during bad times. Factors matter, not asset class labels. Comparing an investor’s set of bad times with those of an average investor allows her to reap factor premiums that will pay off in the long run.”
Andrew Ang
Ann F. Kaplan Professor of Business at Columbia Business School
Market Performance
Below are the indices I track. The month of March really reversed the first 2 months, which were absolutely awful worldwide.
| Indices as of 3/31/16 (% USD) | 1 Month | 3 Months | 1 Year | 3Years | 5 Years | 10 Years |
| S&P 500 | 6.78 | 1.35 | 1.78 | 11.82 | 11.58 | 7.01 |
| Russell 2000 Value | 8.29 | 1.70 | -7.72 | 5.73 | 6.67 | 4.42 |
| Russell 2000 | 7.98 | -1.52 | -9.76 | 6.84 | 7.20 | 5.26 |
| MSCI World ex USA | 6.79 | -1.95 | -8.44 | 1.69 | 1.62 | 1.80 |
| MSCI World ex USA Small Cap | 8.31 | 0.60 | 1.99 | 5.54 | 3.84 | 3.09 |
| MSCI Emerging Markets | 13.23 | 5.71 | -12.03 | -4.50 | -4.13 | 3.02 |
| Barclays Treasury Bond 1-5 | 0.23 | 1.58 | 1.61 | 1.12 | 1.55 | 3.20 |
| BofA Merrill Lynch 1-Year US Treas | 0.14 | 0.36 | 0.40 | 0.29 | 0.32 | 1.74 |
Emerging markets outperformed developed markets during the quarter. The value effect was positive in the US and emerging markets, but negative in developed markets outside of the US. Small caps outperformed large caps in non-US markets but underperformed in the US and emerging markets.
Why Focus on Process v. Outcome
I hear stories about investors who have made a successful short term investment without following a process. Unfortunately, the investor’s behavior most likely will get reinforced due to the positive outcome, as he or she will attribute the outcome to skill rather than chance or luck.
I take an approach that is based on academic research and process. Over the long-term, a systematic process based upon sound investing principles will yield better long-term results than decisions based solely on outcome without a process.
Process is a specific methodology based upon statistically supported principles. It is both repeatable and controllable.
What process do I use?
I focus on factors or dimensions of return that (i) can be captured in the long-term, (ii) are statistically significant and (iii) have some economic rationale justifying the factor. The factors are based on evidence backed by academic research.
What is a factor or dimension of return? It is an investment style that delivers higher return premiums over the long run. As Professor Andrew Ang says, such premiums “don’t come for free, as factors can underperform in the short run (“bad times”).”
A factor must not result from chance. There are measurements in statistics that measure significance or robustness, which are known as t-stats or p-values. What is important to know is that the factors must be significant for me to use them. Also, the factor must work “out of sample.” For example, if the factor works in the US, it should also work internationally and in emerging markets. If it does not, then it is probably not a factor that can be captured.
Finally, even though a factor has a higher return and is statistically significant, it must also have some economic rationale. In other words, it must make sense! Although it must make sense, it does not mean that investors will capture the premium every year.
Robert Novy-Marx, esteemed finance professor from the University of Rochester, published a paper titled “Pseudo-Predictability in Conditional Asset Pricing Tests: Explaining Anomaly Performance with Politics, the Weather, Global Warming, Sunspots and Stars.” In the paper, he cautions investors need to be careful in citing factors that have predictive significance. Methodologies exist that find that the party of the US president, the weather in Manhattan, global warming, El Nino, sunspots and the conjunctions of the planets all have significant power predicting the performance of popular investment theories. Obviously, this does not make sense, and we need to focus on factors that do make economic sense to make sure we do not chase return premiums that probably don’t exist.
To summarize, to be considered a factor, a premium should be:
- Sensible
- Persistent across time periods
- Pervasive across markets
- Robust to alternative specifications
- Cost effective to capture in well diversified portfolios.
So what does my process focus on in the long-term? The following factors/dimensions of returns.
- Stock Market Premium
- Small Company Premium
- Value Premium
- Profitability Premium
How one builds a portfolio based upon factors makes a difference in the long-term. As Professor Andrew Ang eloquently states, “just as eating right requires us to look through food labels to underlying ingredients, factor investing requires us to look through asset class labels to underlying factor risks.”
In addition to the process of focusing on factors, diversifying the portfolio among the different factors makes sure we are never over concentrated in one factor or asset class. In addition, as all investors have different risk tolerances, we must then blend the equity allocation with a fixed income allocation. The amount of the fixed income allocation will depend upon an investor’s risk tolerance and how much risk he or she needs to take to achieve his or her goals.
A good process also minimizes emotional mistakes, which are rampant in investing. Since Nobel Prize winner Danny Kahneman found losses are twice as painful as gains, it is understandable that investors tend to sell at inopportune times, even though it is not in the investor’s long term interest to do so. Sticking to a sound process grounded in a well researched, peer reviewed theory should help investors minimize mistakes and maximize returns long-term.
Unfortunately, many investors have no training whatsoever in Asset Pricing Theory. It is akin to driving blind. In the long-run it is highly likely that they will fall to the level of their training instead of rising to the level of their expectations or hopes.
“One of the key principles of investing is to develop an investment philosophy that you can stick with through thick and thin,” says David Booth, CEO of Dimensional Fund Advisors. How long do you need to stick with that plan? He says 20 to 30 years. By committing for the long haul, Booth said, investors can avoid being corrupted by those killer emotions—fear and greed.
As strategic expert W. Edwards Deming said, “If you can’t describe what you are doing as a process, you don’t know what you’re doing.” It helps to have an advisor who understands proven investment theories and puts a process in place to take advantage of them. By doing so, the process will most certainly result in a good outcome in the long-term.
Make sure your advisor can explain his or her process and philosophy for your best long-term results.
Robo Offering for Small Account Solutions
For new accounts that fall below my $500,000 minimum, I have developed a “robo” offering that has low cost broadly diversified portfolios based upon the asset classes I use for my larger accounts. Instead of using mutual funds, I use a form of a mutual fund known as an exchange traded fund (ETF). By doing so, I can keep costs low. Details are contained in my ADV and at the website below. Whether for children or prospects that have not accumulated assets to meet the minimum set forth above, this is an excellent solution. The link is here. ESG Robo Offering
Links Explaining Factors in Much More Depth
Foundations of Factor Investing
Professor Andrew Ang on Factor Investing
Other Links
Why We Think We Are Better Investors Than We Are
Putting the Client Last: A Former Investment Banker Explains How Investors Are Being Sucker Punched
Is Your Financial Advisor Acting as a Fiduciary? (Hint – A lot are not)