I’d like to follow up two great, baseball-related posts from the team here at Mullooly Asset with another. If you haven’t read Tom or Casey’s posts find them here and here. Specifically, Tom talks about learning a lot about investor behavior by paying attention to team owners in fantasy baseball leagues. I’d like to touch upon this same topic, while relating it to value and momentum investing.

Tom discusses fantasy baseball owners who dump reliable players in slumps for the new flavor of the week. Sometimes these short term leaders turn into season long studs, but more often than not they fizzle out somewhere in between. This leaves the team owner’s roster devoid of proven talent and full of players who were once hot. By erratically chasing short term performance, they likely hurt their chances over the entire season. However, how long do you hang onto the star player who just can’t seem to get it going? It seems like most fantasy baseball owners can’t decide whether they believe in mean reversion or playing the hot hand. If they took a quick lesson from academic finance, they’d realize the answer can be both (at least for investors!).

Many investors neglect one of the largest forces we see in the investment arena, mean reversion. This type of behavior is part of what explains (depending on who you’re asking) the value premium.

 

I think it’s important to note that people looking to invest in the value factor should do so systematically through a process that seeks true value, not junk. Many people likely mistake value investing for buying anything that’s had its price beaten down. While value companies (by nature) have a low price relative to their intrinsic value (however you choose to measure that), that doesn’t mean every stock with a beaten down price is considered a value play. To relate this back to fantasy baseball, you’re not going to pick up some random guy who’s hitting .190 on the season just because his batting average is low. It would be better if the .190 hitter had a solid track record, like a career batting average of .300.

But what about the hot hand? Are we to completely ignore trends in fantasy baseball and the markets? Not necessarily. Some people might point to the momentum factor as an example that short to intermediate term trends are a viable way to seek results.

As Michael Batnick of Ritholtz Wealth Management succinctly described it:

“The simple reason why momentum investing works is because people have a tendency to follow what’s popular and avoid what isn’t.”

Something that simple has resulted in, what Charlie Bilello describes as:

“One of the most powerful and persistent market anomalies. The evidence supporting this assertion is overwhelming. The idea that buying past winners and selling past losers (from 1-12 months) can lead to outperformance, though, is still bewildering to many.”

The momentum factor has been shown to work quite well over time, just like value investing. However, a caveat I’d like to point out is that I think many investors participate in performance-chasing behavior under the guise of momentum investing. If you aren’t systematically deploying a strategy that buys recent winners, I would be cautious about referring to it as momentum. The system needs to be emotionless and disciplined. Case in point, just because some utility player is hitting .500 over the last two weeks doesn’t mean you should hold him for the rest of the season. Momentum strategies are notoriously high-turnover, meaning you latch onto a trend and chuck it when further evidence ceases to exist. An undisciplined momentum strategy is more likely just performance chasing.

Most academic explanations of the momentum and value factors look at top deciles of stocks as ranked by each factor’s criteria. This type of methodology works well, in my opinion, not only because it is systematic, but also because it typically means owning a basket of value or momentum stocks. It produces results that are concentrated enough to see, but diversified enough to not be completely blown up by single stock risk.

As good as these investment factors have proven to be, they don’t always work. Even when they are working well, a basket of momentum or value stocks will have a decent amount of duds included. The aggregate performance of high momentum or value stocks trumps that of any individual stock in the portfolio, making them the recognized factors we know today. I think a problem many fantasy baseball owners run into is that they own a single mean reversion candidate or a just one currently hot hitter. That may or may not work out well. There’s no way to systematically own all the good mean reversion candidates or hot hitters at once. Luckily investors don’t have the predicament that fantasy sports owners face: only one team can own each player.

So the trend is your friend, but watch out for mean reversion too? Yup, it doesn’t have to be one or the other. You are free to invest with both a value and momentum mentality. In fact, the strategies diversify one another nicely. Go ahead, placate your short term desires via momentum, while being a contrarian through value. Just make sure to do them both systematically. As for your fantasy baseball team, good luck!

Now Go Talk About It!