How Do You Make More Money From The Market? Probably Not The Way You Hope To...

9th Sep '13 by Edward Croft

5 comments 6751 reads

One of the greatest cons at the heart of the typical investment sales pitch is that there is a positive trade-off between risk and return - that the more risky the punt you take, the greater your returns will be. This fallacy has become so pronounced that some fund selection platforms have started to publish a slider in the user interface from low risk / low returns to high risk / high returns. As if you can just dial up a certain level of profits for a certain level riskiness. Bah humbug !

This screwy thinking had its origin in the 1960s when some extremely bright academics, probably a little concerned by their diminutive faculty salaries, decided they needed an idea to sell. They came up with the 'efficient market theory' - which boils down to this idea that you can only gain higher returns by taking on more risk. This kind of neat idea sounds wonderful to the investment industry which just adores selling high margin, high risk investment products - so they were very willing customers. Many of these academics became obscenely rich.

Unfortunately the idea just didn't work. Over the last 30 years there has been a growing chorus of dissent against the efficient market theory as practitioners have discovered something quite unusual. In practice, investing in low risk shares generates higher returns than investing in high risk shares. The slider works the other way around!

Warren Buffett, the richest investor in history, dialed up his own fortune by standing diametrically opposed to these ideas. A famous study called "Buffett's Alpha" attempted to reverse engineer his investment style - discovering that to achieve his level of extremely high returns required systematic investment in low risk, high quality stocks. Are there any billionaires with his kind of long term outperformance that have ever won by consistently investing in high risk shares?

The gamblers fallacy

Why should safe, low volatility shares outperform? It most likely comes down to the fact that people love to gamble. Think about it - how much more interested are you in investing in the stock market when the stock market is going up? And when you start to get that itch, which kinds of stocks do you feel you want to start buying? If you are anything like the majority, it's the stocks with the highest likelihood…

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Edward Croft

9th Sep '13

Another example of a possibly topsy turvy risk return slider - this time from Nutmeg...

If you really want to understand the real risk of a share or strategy - you need a better thinking framework.

Mark Simpson

Good paper, thanks for the link Ed.

Some random thoughts:

Interesting to note that Asness et al find that their QARP (Quality at a reasonable Price) strategy of combining value with quality had the highest Sharpe Ratio at 70% Quality Minus Junk (QMJ) and 30% High Book to Market Minus Low (HML) for US stocks and 60-40 for Global Stocks whereas Gray & Carlisle in Quantative Value find that Greenblatt's Magic Formula consistently overpays for quality in his ranking system.

QV found that Earning yield was the best value metric so using this could push the optimum more towards the value strategy compared to B/M, but still maybe the quality rank should be more weighted than QV suggest it should be.

It seems that maybe the issue with the magic formula was not the concept of using quality but a too narrow definition of what constitutes a quality company. Both QV & Asness et al use a number of factors to identify quality companies.

Asness et al also show that quality is persistent which is a very important point when using historical ratios to form portfolios for future outperformance.

I like how QV excluded companies at risk of being earnings manipulators or at serious risk of financial distress. They didn't however demand the highest earnings quality or lowest risk just that they excluded the worst 5%.

Asness et al introduce an interesting additional factor of Payout consisting of net equity issuance, net debt issuance and payout ratio which could be added as an additional quality factor in the stockopedia quality rank.

Their Safety factor also has a couple of interesting additional factors to do with volatility - beta, idiosyncratic volatility and ROE volatility which are in the CHS model to some extent but may be worth including as a separate factor.

Seeing all these terrible risk-return sliders maybe you could show them how it should be done and implement a proper slider system where users could slide up and down the stock ranks (and sub-ranks ideally if you are able to implement these) a simplified screener interface?

Cheers,

Danger

10th Sep '13

Hi danger,

I think their paper is a fascinating read. I liked that they incorporated an element of sustainable growth into the quality factor. The issue we have with the growth rank is that high growth (/low growth) has a tendency to mean revert. i.e. the best growth companies in any given year tend grow more slowly in future, while the worst growth companies tend to grow more quickly in future. This is natural when you think about it - companies up against it get new management and make tough decisions, while successful companies often get complacent.

As a result we are inclined to exclude the Growth rank from an overall site Composite Rank (which will likely be rebranded as the StockRank). The StockRank will likely be more of a Quality + Value + Momentum factor once complete. We are still working on the optimum composition and backtesting variations.

I thought the Quantitative Value book was excellent - but choosing the Earnings Yield as preferred metric over and above the blended composite value score I think may be short sighted. There have been so many famous papers / books written lately heralding the Earnings Yield (and so many private equity companies launched that focus on cashflow variables) that I don't believe the future returns will be anything like as strong as the past. I was hugely pleased to see that blended value ratios work almost as well - it's a much more robust methodology that ought to be more robust to temporary market fads (such as for P/S in the internet bubble, P/CF in noughties, Dividend Yield today).

Re. Sliders - we do have plans... just lots on the plate !

Hi Ed,

I agree on the Growth Rank - I exclude it from my investment decisions since of the four factors it's the one the market (on average) overpays for whereas the rest the market underpays for.

The growth factor that Asness et al use is in fact growth of profitability - the five year delta of their profitability quality factor - not necessarily growth in earnings (although you'd expect a company with growing gross margin etc to grow earnings just not necessarily at a overall high rate.) To me this is akin to QV taking the max of Profit Margin stability or growth, You want a company that has high and stable margins, ROE etc. or one that is improving but it's very hard to have both so you should use both factors.

Re:earnings yield vs composite rank - although QV didn't find any benefit I don't think it matters that much apart from ease of calculation and seeing as you have it already then it makes sense to use it.

As you can see from my mind map the quality rank is the one that is most complicated and the one that also adds the most value as a composite rank so spending some time getting it right definitely makes sense. I still think that something like the quality sub ranks for the different concepts of quality (like the four factors that Asness et al choose) in my mind map would give the most flexibility and the best way to screen for advanced users - I hope that you'll be able to do something like this even if its as a later enhancement?

Cheers,

Danger

emptyend

11th Sep '13

Hi Ed,

high growth (/low growth) has a tendency to mean revert. i.e. the best growth companies in any given year tend grow more slowly in future, while the worst growth companies tend to grow more quickly in future. This is natural when you think about it - companies up against it get new management and make tough decisions, while successful companies often get complacent.

I agree with that thought. The other factor is that in very many cases (all but the largest companies, I suggest!) the growth characteristics are the product of the efforts of a pretty small management team - and there is a need to bear in mind that they are only human!

Most management teams only get to the top of their businesses in the 40s and 50s - and typically retire sometime in their 60s. As they do so, they will be replaced by different people who will certainly see things differently and act differently. Sometimes this allows the business to continue to crest the growth wave - but only if they have promoted/hired the right people and the business fundamentals also continue to allow growth. More commonly "something" goes wrong with the growth path as key people retire. For examples (in large businesses) consider Greenbury at M&S or Leahy at Tesco.

IMO a big part of the trick in spotting growth opportunities is to spot a relatively young and capable management team operating in industries which have promising fundamentals. For example, I was very tempted to invest in Tesla in 2010 when the shares were $20-25 (Tesla make electric cars and are run by the entrepreneurial 40-ish Elon Musk). The shares are now $166 - and I didn't invest, unfortunately. One reason I didn't "get round to it" is that the concept was obviously high risk, in a segment that has large entrenched competitors - and there was no particular trigger to enter a position; another reason was that to invest would have required selling investments that seemed much safer but which still offered growth potential. Ex-post, of course, it was the wrong call and I've missed an 8-fold gain in under 3 years.......but looking back at why I missed it, I think a big part of the reason comes down to having failed to fully factor in the age and objectives of key managers - so perhaps there is a case for expecting growth companies with managers in their 60s to be more likely to go ex-growth than those with managers in the 40s? Though perhaps there is also a bigger risk of going bust due to excessive risk-taking.

As ever, it ain't easy......even with screens.

ee

How do you make more money from the market? Probably not the way you hope to...

The gamblers fallacy

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Edward Croft

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