Jaffe: Beware systems that promise superior returns
BY CHARLES JAFFE Market Watch
Wednesday, November 21, 2012
11/21/12 at 3:30 AM
If someone tells you they have come up with an investing system or methodology that delivers a predictable edge over ordinary stock market returns, they may be right.
They just won't be right for the long.
In the stock market's unique way of beating up on braggarts and know-it-alls, the fastest way to turn market-beating methods into average results is to let the world know what you've got. In fact, a recent academic study that looked at academic research purporting to give investors an edge found that the mere act of publishing a research paper to announce the results to the world was enough to crush the advantage of the strategy.
And that's writing for academic journals, it's not basing a mutual fund, newsletter or any other investment product that might be selling its strategy as delivering a specific above-the-norm difference.
That's why any investing purporting to follow a strategy that surpasses the market returns by a predictable amount is investment insanity, making an age-old mistake where you are hoping to achieve something different in the end.
The problem with any claims or predictable, advantageous returns is clearly pointed out in a recent research paper "Does Academic Research Destroy Stock Return Predictability," written by David McLean, a visiting professor at MIT, and Jeffrey Pontiff of Boston College.
The professors looked at 66 different studies which basically plumbed the depths of 82 different market anomalies that were supposed to lead to predictable gains.
Of course, academic studies have some real-world flaws. They typically ignore trading costs and other friction that real-world investors can't shake off. That's why it can be tough to implement these strategies to get what the academics predicted.
But it gets worse.
"After the paper has been published, it looks like people do start to trade on these and the average strategy declines by about 35 percent," said McLean, "so if a published paper says you can make X percent returns on this strategy, after the paper has been published the return is 35 percent lower."
Once you take 35 percent off the top because everyone else is trying to do the same thing, McLean acknowledged that the advantage is gone.
The drop-off is even greater when the strategy is concentrated in investment areas that are easier and less costly to trade in, such as big, brand-name stocks. The easier it is for people to emulate the strategy, the faster the edge disappears.
Consider, for example, a "Dogs of the Dow" strategy, which involves buying the highest-yielding stocks that are part of the Dow Jones Industrial Average. It's a strategy that a conservative investor can be comfortable with, but they can't necessarily expect it to beat the market consistently; in the last six full calendar years, for example, a Dow Dogs strategy topped the Standard & Poor's 500 index three years, and lagged it in three others.
Similarly, the Motley Fool's "Foolish Four" strategy - a mechanical high-yield/low-price strategy - garnered a lot of attention from 1994-2000, when the online investment community espoused it as a way to get significant outperformance compared to a total-market index fund.
Ultimately, the firm's own research showed that the edge was not nearly as predictable or significant as initially expected.
That didn't mean the strategy was taking investors to the poor house - it didn't, and there are still believers in it today - but that people using the method to gain an edge really never had an advantage.
"If you feel strongly about an investment style or method, that's good, and that's going to help you be successful with it," McLean said, "but if you believe that a strategy is going to give you 2 percent better than the market - or if a newsletter or mutual fund tells you their strategy can deliver that all the time - it's just not going to happen."
Further, McLean noted that there are plenty of times when investment theories are the result of "data mining," the practice of finding the numbers that support a hypothesis.
While McLean was optimistic that most of the academic studies he and Pontiff reviewed focused on legitimate market anomalies, he acknowledged that there's no way to know.
Ultimately, there are plenty of investment practices that average investors can gravitate toward; from buy-and-hold to swing trading, tactical asset allocation to technical analysis, there's no one right way to make money.
And if you have found one you can be comfortable and that gives you a return you can be comfortable with, McLean said, stick to it.
But if you think the strategy gives you an edge on the market, shut up.
The minute you tell the market how smart you are, the market is coming to get you.
Original Print Headline: Beware systems that promise superior returns
Chuck Jaffe, senior columnist for MarketWatch, can be reached at email@example.com or at Box 70, Cohasset, MA 02025-0070.