I recently read Jim O’Shaughnessy’s What Works on Wall Street for the first time. This is undoubtedly a book that I’ll be returning to time and time again, as there’s no way I absorbed the entirety of its wisdom on first pass. However, I did take away a great deal from my first experience with Jim’s book. I wanted to share some of the broader concepts that I encountered while reading What Works on Wall Street. These are invaluable lessons that all investors would benefit from learning.
All Strategies Have Performance Cycles
The story is the same for buy and hold investors, momentum investors, value investors, and followers of other styles of investing. No matter what your investment strategy is, there’s going to be a time period when it underperforms. History has shown us that even the best factors invert from time to time. It won’t be pleasant watching your strategy get pummeled by others, but it’s all part of the game when you’re a systematic investor. Hopefully, there’s also a time period when the strategy rewards your patience with outperformance. As Jim put it in his book, “The key to success is unwavering disciplined implementation of an investment strategy”. This means that you must be willing to stick with your strategy through its performance cycles. After all, the S&P 500 is nothing more than a one factor model that weights stocks according to market capitalization. The only reason it outperforms the vast majority of conventionally managed funds is because it never deviates from its parameters. The S&P 500 can’t get nervous and stop buying large cap stocks because it isn’t human. If you can’t stick with a strategy for the long haul, it’s not for you.
We Are a Bundle of Inconsistencies
Since all strategies have performance cycles, their successful implementation is largely determined by the individual investors who use them. Periods of underperformance hurt in real time, even if we understood that they would occur beforehand. Our brains try everything they can to convince us that, “It’s different this time, the strategy must be broken!”. In reality, what allows successful investment strategies to work over time is human emotion. Disciplined investors get to arbitrage the reactions of their less disciplined peers.
In many cases, investors know they’re making a mistake when they abandon an investment strategy, but ignore what they know for what feels good. This is driven by cognitive deficits like overconfidence and recency bias. We all believe that we’re above average at the things we do, despite the fact that we all studied bell curves in high school statistics class. We also tend to time-weight information, which often leads us to make irrational choices driven by the present. Other behavioral issues that affect us all include, but are not limited to, hindsight bias, anchoring, confirmation bias, and projecting our personal experiences. Notice that I wrote, “affect us all”. This was possibly the most valuable message on biases that Jim shared. We are all just as susceptible to behavioral biases as the next person. None of us are immune, and that is why systematic investing in time-tested strategies works. Irrational human behavior has stood the test of time, and utilizing strategies that capitalize on it is a great way to invest.
Factors are Better Together
You don’t have to subscribe to a single investment factor. In fact, you’d be well served not to. Whether we’re talking about market capitalization, relative strength, price to sales ratio, shareholder yield, EBITDA to enterprise value, P/E ratio, or any other factor, you can likely improve results by teaming them together. Diversifying across investment factors not only helps improve returns, but can often decrease risk at the same time. You should invest in a combination of strategies that fit your individual tastes and risk tolerance. Strategy diversification can help smooth the ride and keep you from jumping ship at the wrong time. Jim encourages investors to, “Make stocks pass several hurdles before investing”. I agree, why line up just one hurdle, when you can set up an entire row?
These were just three of many lessons I learned from reading What Works on Wall Street. If you haven’t read this classic already, I highly recommend checking it out.
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