James (Jim) O’Shaughnessy is a renowned investor, author and Chairman of O’Shaughnessy Asset Management. He is well-known for his book ‘What Works on Wall Street’. It was one of the first investment books I read when I started my career. However, what I found most interesting about his achievements was the research he published in his first book ‘Invest like the best.’
In 1987, Jim worked as a consultant for various pension funds. During this stint, he studied the performance and portfolios of seven separate pension funds in detail. He profiled the fund managers based on their strategy and the factors they used to make investment decisions. Using this information, he prepared a set of rules that would mirror the strategy of these fund managers – in essence, a clone portfolio.
In a year’s time, when he evaluated the performance of the clone portfolios vis-à-vis those of the fund managers (that were being cloned), he found something very interesting. All the clone portfolios were beating their fund managers in terms of returns!
He repeated the performance evaluation after a few time intervals, and yet the story remained the same. What was the reason for this difference? After all, the clone portfolios were merely trying to mimic the fund managers’ strategy. The difference was: discipline. The clones followed the rules of buying and selling exactly as per the strategy, but the fund managers deviated periodically.
There are many studies done in the past to understand the superior returns generated by certain investors over the long term. These super-investors have different strategies and investment styles. But they have one characteristic in common – discipline. The case is the same in short-term investing styles too. Jack Schwager who has written some impressive books under the ‘Market Wizards’ series says, “When I asked the Market Wizards what differentiated them from the majority of traders, the most common reply I got was “discipline.” Success in investing is like going on a diet plan: one can learn and draw up a fantastic, high-return, proven strategy on paper. But it counts for nothing unless followed with discipline.
Your key competitor tries to beat you on discipline
Most of us compare our performance against a broad-based generic benchmark. That is the measurement of our opportunity cost and that is the competition we try to beat. How does this competitor of ours invest? Most of these indices consider market capitalization (size, based on total or free float), liquidity (generally in trading frequency and impact cost), listing history, profitability criteria and any other country-specific restriction. The companies are selected based on specified criteria that are followed by a formula-based weight allocation strategy, which is reviewed on specific periods of time. This competitor neither looks at any economic forecasts nor understands the business it is investing in.
But this competitor beats many fund managers mainly on discipline (without performance pressure!). It follows its path without worrying about what others are doing.
Need to be disciplined through the cycle
There are many different strategies, factors and styles that investors adopt to beat the market. Some of them don’t work at all. But, of the ones that do work, none click all the time. Each one has a phase of underperformance. Many super-investors have undergone painful underperformance for a long period of time. However, they have generated superior returns over a longer run because they stuck to their philosophies and did not switch their styles during downturns.
Markets have cycles of booms and busts. And so do investment styles. If investors give up discipline and succumb to emotional pressures, the resultant inconsistency in decision-making will often lead to poor returns. Changes in the core philosophy also impact predictability of future performance. When an investor changes the style, for example, from value to momentum, the past performance becomes irrelevant in determining future expectations. The pressure to change is highest at the lowest point of underperformance. Abandoning a good investment approach during this time may lead to a lack of participation in the rally and, in a worse scenario, positions one in a downcycle of the new approach.
In investing, you have to deal with complexity and uncertainty. But that doesn’t mean you need be extra clever and think out of the box every day. Once a good, time-tested and profitable, investment approach or style is identified, one has to focus on executing it well. This approach or style can have multiple factors or combination of variables.
For example, in ‘The Little Book that beats the Market’, Joel Greenblatt speaks about the ‘Magic Formula’ that combines two factors: a) business quality (Return on Capital) with b) value (Earnings yield). He shows how this simple formula delivers good index-beating returns to investors over the long term. But he also highlights that the challenge is to stick with a formula during the times it underperforms so that you don’t miss out on the years that it delivers superior returns.
Once you identify a successful way of investing, clone yourself. Like James O’Shaughnessy did for the pension fund managers, make investment rules such that some decisions are automatic. Make an algorithm out of your secret sauce of success. This clone will keep you disciplined.
This clone should help you make the success repeatable. The algorithm should run the regular steps in the process like you would, but it should do it automatically with defined rules. For instance, steps such as:
-Screening the investment universe for the characteristics that qualify for your investment approach (Screeners)
-Ensuring that important data and analytical steps are being followed (Investment checklist)
-Undertake scenario analysis through external as well as internal estimates (Bull-Base-Bear Cases with probabilities)
-Design an ideal portfolio allocation based on probabilities and payoff with other risk limits or criteria (Allocation formula or program)
Investors choose different styles to beat the market, depending on their own skills, research, goals, time horizons etc. But irrespective of the style, a clone can act as a behavioural support system, nudging them to be disciplined and thereby helping generate superior returns from that style.