We all know that having a sound process is crucial to investing success. Finding something that works over the long-term and adhering to it through the inevitable ups and downs that the market brings is essential to achieving our goals. This is particularly true in the world of systematic investing that I live in. If you are going to call yourself a systematic investor and you don’t adhere to your system, then you probably aren’t going to have much success.
But having a process doesn’t mean you shouldn’t ever change it.
The market changes over time. Strategies that work for very long periods of time will sometimes stop working. As an investor, you need a framework to deal with that. For me this has always been the most challenging part of running quantitative strategies. On one hand, you have to stick to your strategy to be successful. But on the other, if you blindly continue to follow a process that no longer works, you won’t be successful either.
So how do you decide when to change your process and when not to?
If you are looking for a definitive answer to that, you have turned to the wrong guy because I don’t have one. And I don’t think anyone else does either. But I have found some general guidelines to be helpful in dealing with the issue over time.
Here are some criteria I have found useful in making that decision.
1. What Does The Long-Term Data Tell You?
Long-term data is at the core of what many of us do as investors. We want to invest using strategies that work over time. With many strategies like value, we can look at over 100 years of data to help us figure out what works. But figuring out whether an investment strategy should be utilized going forward isn’t as simple as just looking at the long-term data.
To illustrate this, let’s pretend I use a value strategy that utilizes the Price/Book. If my criteria for selecting an investment strategy is that I want it to be based on long-term data, that strategy would meet it. There is significant academic research that shows that there is a value premium over the long-term. And much of that research was done using the Price/Book.
But there are two problems here. The first is that when a particular approach that has worked historically stops working, it can take a really long time before we can conclusively prove it with the data. Corey Hoffstein showed this is his excellent article Factor Fimbulwinter. Corey looked at how long it would take before we can say with statistical significance that a factor like the Price/Book doesn’t work anymore. He found that period is longer than most of our investing lifetimes. So data sometimes can’t provide the answer.
The other point to keep in mind here is one that Adam Butler from Resolve Asset Management made when he appeared on our podcast. He explained to us that the past is only one sample draw out of an infinite series of possible sample draws. What he means by that is that there were many different ways the past could have played out. And many of those could have led to very different investing outcomes than the ones we have seen. This is really important to keep in mind as all of us look at the past and evaluate it. As a simple example, think about what we have seen in the bond market in the past 40 years. Consistently falling rates have favored a specific set of investment strategies over others. But what if we don’t see that same version of the world in the future? Many of the investment strategies that we now assume work and can support with 40 years of data may prove much less successful than we think.
If data can’t provide the answer as to whether things have changed with an investment strategy, what can? The answer to that gets to my second point.
2. Does the Strategy Still Make Sense?
Returning to our Price/Book example, this is where that strategy can really be called into question. We live in a world where intangible assets have become a much bigger part of the total value of companies than they once were. Things like technology and patents and intellectual property are a huge part of our economy today. But for the most part they don’t show up in book value. Evaluating a company like Google or Facebook using the Price/Book is largely a useless exercise.
So despite the long-term data supporting the Price/Book, I could reasonably conclude that it might not make sense in today’s world and I might not be able to rely on the long-term data supporting it if much of that data comes from a period that was different.
As a quant I hate this because I want to have a purely systematic process. But there is no getting around the fact that there is no such thing as a purely systematic process. Human judgement has to come into the process at some point.
3. Is There a Win-Win?
When thinking about changing an investment process, my first step is always to look for a win-win. Returning to the Price/Book example, we have looked at why using data to determine whether it still works is very difficult. We have also talked about bringing human judgement into the process and trying to look at the arguments against it. But sometimes there are ways to avoid having to draw binary conclusions or having to make major changes to an investment process.
Doing this involves taking a step back and looking at the core of what you are trying to accomplish. Investors who invest using the Price/Book are looking to take advantage of the value premium. But there are many other ways to measure value that don’t use the Price/Book. The Price/Cash Flow has long-term historical evidence to support it. So does EV/EBITDA. And those measures don’t have the same issues as the Price/Book.
So for investors who use the Price/Book as part of a value composite, eliminating it and just using all the other metrics is a viable solution because it maintains the core idea of the investment process, but eliminates the issues surrounding the Price/Book. Or even if you don’t use a value composite, the Price/Book can be replaced with other metrics to accomplish the same goal. I have found that this if often true with other investment process changes as well. Much of the time there is a way to adjust a process to get around potential issues without changing its core ideas.
The Process of Constant Evolution
In the end, there is no magic bullet to help decide when to change an investment process. As a quant I wish the decision could be made using a purely systematic process, but there is no way of getting around the fact that human judgement has to play a role. For any process that has worked over time, the bar for changing it should be high in my opinion. But that doesn’t mean that bar should never be crossed. I have found that using the rules above is helpful in that regard.
Originally Posted November 20, 2022 – Knowing When to Change Your Investment Process
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