Tuesday, May 28, 2013

All Investment Strategies Stop Working At Some Point

I was talking to an advisor earlier in the week about tactical asset allocation and he conveyed a story about how he had allocated money to a tactical strategy that stopped working.    Every investment strategy stops working at some point, either temporarily or permanently: Buy and Hold and asset allocation in 2002 and 2008, the legendary Bill Miller at Legg Mason in 2007, and yes, even a tactical strategy.

Market dynamics are constantly changing, it would be foolish to expect an investment methodology to work all the time in every type of market, or never just stop working.  How do you protect against this:

1. Use multiple, uncorrelated, methodologies.  We use intermediate term momentum analysis that buys into something when it is going up and sells when it starts to weaken, combined with short term counter trend analysis that buys when something is weak and sells when it is going up.  These methodologies do not move in the same direction at the same time and use completely different metrics.  If one stops working the others will not be impacted.  

If you insist on using some sort of buy and hold or asset allocation strategy you would need to combine it with a completely different return stream.

2. Define for whatever strategy you are using what ''stop working'' means.  For us, this is a strategy that doesn't perform as it should.  For example, a momentum strategy that doesn't do well in a market that is favorable for momentum or a counter trend strategy that doesn't do well in a market that is favorable to counter trend.

3. Understand that all strategies stop working at some point and constantly monitor everything for any signs that it is not working properly.

4. If you identify a strategy that is not working as it should figure out why and if it is temporary or permanent.  Err on the side of caution here.  Over the years I can think of two models we had that stopped working as they should.  They relied on inter-market relationships that had always been strong and ceased to be so.  We decided that these changes in the market dynamics were most likely permanent and took the models out of our strategies.

5. Most importantly, always be improving.  It is tempting to find an investment strategy with a great long term track record and assume it will continue, it won't.  Being static and/or relying on track records is a recipe for disaster.  Look at all the companies through the years that went out of business because they assumed that what worked in the past will continue (anyone interested in a buggy whip?) We are in a constant state of improvement.  There is always a better way to do what we do and I spend hours every day trying to find it.  When I do, then I try to find something better than what I just found.

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