Subscribe: RSS
There’s a stigma surrounding home exercise DVD programs, I get it. Maybe it’s driven by the infomercials or the way they seem to gather cult-like followings. Either way, I’m willing to admit that I’ve become a Tony Horton disciple over the last few years. Every morning I pop in a P90x DVD and get my daily workout in. I’m confident that Horton’s program has improved my health.
Muscle confusion is P90x’s foundation. It helps fight the plateau effect by continually mixing up workouts. On any given day you could be in for cardio, resistance training, mixed martial arts, yoga, Pilates, or intervals. There’s no way for your body to get used to it, and that’s the beauty of the program. You’ll eventually adapt to any one of those exercises on their own, but when they’re constantly rotated within a program, your body is left guessing. It also helps you avoid boredom from too much of one exercise type. Boredom often leads to slacking off or quitting entirely.
This isn’t all too different from the idea of factor diversification. Different investment factors are cyclical in nature, and diversifying them can help smooth the ride.
A classic example of factor diversification is combining value and price momentum (or relative strength). Value investing works, but it has the tendency to be early. Momentum investing works, but it’s sometimes volatile. Both factors have outperformed the market over time, but neither of them works all the time.
Jack Vogel of Alpha Architect did an excellent two part series of combining value and momentum strategies. The premise is that pure versions of these strategies held in conjunction can generate higher returns, higher Sharpe Ratios, and lower standard deviations than either can on their own.
Back in January, Patrick O’Shaughnessy was interviewed by Barry Ritholtz on his Masters in Business series. The two spoke about several topics, but one that applies to factor diversification is Patrick’s checklist for active investors. In order to identify stocks worthy of investment, Patrick urges investors to look for stocks with high shareholder yield, high return on invested capital, operating cash flows greater than reported profits, enterprise value to free cash flow less than 10x, and 6 month price momentum in the top three quarters of the market. This is another excellent example of factor diversification. Rather than rely on any one of the five factors alone, the combination of many is what provides optimal results.
Patrick’s father, Jim O’Shaughnessy, is also an advocate of multifactor strategies. In his classic book, What Works on Wall Street, Jim discusses many investment factors including value and relative strength, as well as various accounting principles. One of the main themes I took away from reading What Works on Wall Street is that factors are better together. The best performing strategies from the book were all combinations of several factors. Jim also makes an excellent case for combining value and momentum investing.
Finding an investment strategy that works is easy, it’s sticking with it that’s hard. Tadas Viskanta of Abnormal Returns recently blogged about this, writing:
“Strategies are easy to adopt. Almost too easy. The challenge is in following through with the strategy through thick and thin.”
I believe this is similar to finding a workout regimen that produces results. It’s easy to get hooked on running, lifting weights, yoga, or martial arts. However, you’ll almost inevitably reach a period of time when it becomes boring or your results lag, causing you to contemplate quitting. A diversified exercise program like P90x strives to avoid the moment when you want to quit by mixing up the routine.
The same can be said for a portfolio that diversifies across investment factors. No investment strategy works all the time. That’s a fact of life. By diversifying across factors, you can smooth the ride and also help fight the urge to abandon ship when a strategy goes through an inevitable period of underperformance.