Jim O’Shaughnessy: Build Portfolios That Deliver Alpha Without A Wild Ride

In his recent interview on the Real Returns podcast Jim O’Shaughnessy explained why investors need to build portfolios that deliver alpha without a wild ride saying:

What we really have to find are strategies that do better than the market over long periods of time but that investors can actually stick with. Okay, so that takes a lot of really interesting strategies, I mean to people like us, off the table because they do incredibly well if you’re Rip-Van-Winkle and you don’t look at the portfolio for 10 years. You’ll wake up really happy. But that isn’t the way human beings are. Some people look at their portfolios daily, hourly, it’s horrible and toxic to your returns. Lots of academic studies back this up and yet human nature right. You’re never ever gonna overcome human nature.

I say that’s the last sustainable edge. Arbitraging human nature. So for a quantitative factor investor what we have to strive for are portfolios that take maximum advantage of the anomalies in the factors but also keep a keen eye on downside variability. In other words, everybody right, don’t look at standard deviation of return right because that includes up and down. When stocks are going up you want the highest standard deviation you can have right. It’s only when stocks are going down that people freak out and so you can look at the downside risk.

You can look at all of those things. How often. What was its biggest maximum drawdown. All of those became much more important to us as we evolved our strategies. So I think what you see us offering today are portfolios that very much take that into consideration.

These are portfolios where we’re still trying to do the best in generating alpha but in a manner that doesn’t create a wild wild ride that people simply can’t hold on right.

So we’re taking our understanding of human nature into account and and looking for those sweet spots where we’re paying attention to financial strength. We’re paying attention to quality. We’re paying attention to all of those things and excluding companies that might have a great potential upside but also are so volatile that when that bad volatility hits, and note I say – when not if – you’re deluding yourself if you think you’re not gonna have drawdowns. Everybody has drawdowns.

So the advantage to being a systematic investor is we can look at how bad they were, and sometimes they’re very bad. What we try to do now is marry the best alpha that we can find to a drawdown that we feel that our average client – and I hate that word because we don’t have an average client right – everyone’s different. Everyone’s interpretation of risk is different.

All of those things need to be taken into account. But in the absence of doing something specifically for Jack and for Justin and for Jim, which we’re getting closer to being able to do, but that’s another story. You want to say okay can somebody with a normal reaction to a market loss stay and stick with it and what we’re finding is that yes as we’ve evolved our portfolio strategies – taking the risk that they face in the market into account is part of the process.

When I first did all of our original strategies I was in my early 30s and loved risk. Then I had the enlightening awakening that most people don’t love it. Most people hate risk and that’s why you see unfortunately the risk
aversion anomaly where they hate risk so much that they need a lot more upside than downside and markets don’t
work that way.

You can watch the entire the entire interview here: