Find A Simple Strategy With An Acceptable Level Of Risk And Stick With It – What Works On Wall Street

Johnny HopkinsJames O’ShaughnessyLeave a Comment

One of the best investing books ever written is What Works On Wall Street by James O’ Shaughnessy. The book is full of a number of investing gems but one which struck a chord with me was O’ Shaughnessy’s advice on finding a simple evidence based strategy, with an acceptable level of risk, and sticking with it. He goes on to make the point that successful investing runs contrary to human nature, which is that we tend to overcomplicate simple successful investing strategies.

Here’s an excerpt from the book:

William of Ockham, a fourteenth-century Franciscan monk from the village of Ockham, in Surrey, England, developed the principle of parsimony, now called Occam’s Razor. For centuries it has been a guiding principle of modern science. Its axioms—such as “what can be done with fewer assumptions is done in vain with more,” and “entities are not to be multiplied without necessity”—boil down to this: Keep it simple, sweetheart. Occam’s Razor shows that most often, the simplest theory is the best.

This is also the key to successful investing. Successful investing, however, runs contrary to human nature. We make the simple complex, follow the crowd, fall in love with the story about some stock, let our emotions dictate decisions, buy and sell on tips and hunches, and approach each investment decision on a case-by-case basis, with no underlying consistency or strategy. We are optimistically overconfident in our own abilities, prone to hindsight bias, and quite willing to ignore over half century of facts that show this to be so. When making decisions, we view everything in the present tense.

And, because we time-weight information, we give the most recent events the greatest import. We then extrapolate anything that has been working well recently very far out into time, assuming it will always be so. How else could the majority of investors have concentrated their portfolios in large-cap growth stocks and technology shares right before the technology bubble burst and the biggest bear market since the 1970s ensued?

It’s extremely difficult not to make decisions this way. Think about the last time you really goofed. Time passes and you see: What was I thinking! It’s so obvious that I was wrong, why didn’t I see it? The mistake becomes obvious when you see the situation historically, drained of emotion and feeling. When the mistake was made, you had to contend with emotion. Emotion often wins, since, as John Junor says, “An ounce of emotion is equal to a ton of facts.”

This isn’t a phenomenon reserved for the unsophisticated. Pension sponsors have access to the best research and talent that money can buy, yet are notorious for investing heavily in stocks just as bear markets begin and for firing managers at the absolute bottom of their cycle. Institutional investors say they make decisions objectively and unemotionally, but they don’t. The authors of the book Fortune & Folly found that, although institutional investors’ desks are cluttered with in-depth, analytical reports, the majority of pension executives select outside managers using gut feelings. They also keep managers with consistently poor performance simply because they have good personal relationships with them.

The path to achieving investment success is to study long-term results and find a strategy or group of strategies that make sense. Remember to consider risk (the standard deviation of return) and choose a level that is acceptable. Then stay on the path. To succeed, let history guide you.

Successful investors look at history. They understand and react to the present in terms of the past. Yesterday and tomorrow, as well as today, make up their now. Something as simple as looking at a strategy’s best and worst years is a good example. Knowing the potential parameters of a strategy gives investors a tremendous advantage over the uninformed. If the maximum expected loss is 35 percent, and the strategy is down 15 percent, instead of panicking, an informed investor can feel happy that things aren’t as bad as they could be. This knowledge tempers expectations and emotions, giving informed investors a perspective that acts as an emotional pressure valve.

Thinking historically, they let what they know transcend how they feel. This is the only way to perform well. The data in this book give perspective. It helps you understand that hills and valleys are part of every investment scheme and are to be expected, not feared. It tells you what to expect from various classes of stocks. Don’t second guess. Don’t change your mind. Don’t reject an individual stock—if it meets the criteria of your strategy—because you think it will do poorly.

Don’t try to outsmart. Looking over 52 years, you see that many strategies had periods during which they didn’t do as well as the S&P 500, but also had many that did much better. Understand, see the long-term, and let it work. If you do, your chance of succeeding is very high. If you don’t, no amount of knowledge will save you, and you’ll find yourself with the 80 percent of underperformers thinking: “What went wrong?”

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