Tag Archives: modern

HARKing Back: Lessons In Investing From Science

Confirm Ye Not Here’s what ought to be a really boring idea – we need scientists in general and psychologists and economists in particular to stop hypothesising after results are known (HARKing, geddit?). Instead, they need to state what they’re looking for before they conduct their experiments because otherwise they cherry pick the results they find to confirm hypotheses they never previously had. The underlying problem is our old foe, confirmation bias . And the solution for scientists and social scientists alike is known as pre-registration. It would be no bad thing for investors to demand a similar process for fund managers and financial experts. Or, for that matter, to apply some of the ideas to their own investing strategies. No No Negatives It’s been known for years that a lot of scientific research isn’t very reliable. There are numerous problems, chief amongst them being the non-publication of negative results: an issue known as publication bias . There’s no kudos in showing that your hypotheses were wrong, so researchers and corporations tend to bury the data, but it’s still valuable information that should be shared: scientists see further by standing on the shoulders of others, we shouldn’t be encouraging them to shrug them off because they’ve got bored. Worse still, though, is the fact that many studies turn out not to be replicable. The ability to re-run an experiment and produce the same result is an absolute cornerstone of the scientific method : science works because it’s not built on faith, it’s constructed out of evidence. If it turns out that the evidence is unreliable then what’s being done isn’t science, it’s more like religious studies with instruments. Or economics. Repeat, Again Once we move to the social sciences then the problems are even worse. Human beings are terrible things to experiment on , being inclined to change their minds, develop opinions about the experiments and to second-guess what the researchers would like them to do, just to be nice. All too many experiments in the social sciences turn out to be flawed because of social or situational factors that didn’t seem important at the time. Given this, you’d think that repeating experiments to make sure the results held would be even more important for psychologists than it is for researchers in the hard sciences. Well, guess again. According to research by Matthew Makel, Jonathan Plucker and Boyd Hegarty , only a little over 1% of psychology studies have ever been replicated. Everything else is simply a matter of faith in the integrity and lack of bias of the original researchers. Which is not science: in the words of John Tukey, quoted at the head of their paper: “Confirmation comes from repetition. Any attempt to avoid this statement leads to failure and more probably to destruction.” Pre-Register The best solution to this we’ve yet found is known as pre-registration: studies have to be registered in advance, and the hypotheses under investigation stated up front before the research is done. This prevents the experimenters from looking at their data after the event and picking out interesting positive correlations which they didn’t control for, but which are likely to get published. Where pre-registration has happened the proportion of studies giving positive results has fallen dramatically: analysis of studies into treatments for heart disease have shown a frightening drop in positive results since pre-registration was mandated: “17 out of 30 studies (57%) published prior to 2000 showed a significant benefit of intervention on the primary outcome in comparison to only 2 among the 25 (8%) trials published after 2000”. Some of this may be because the low-hanging fruit on the subject was picked earlier, but it’s a scary result all the same. It seems likely that because the researchers can no longer consciously or unconsciously pick the results, they prefer they remove the possibility of confirmation bias – and the fall is so dramatic it places the previous results in question. And, of course, it’s not clear how many of those have been replicated. Creative Scientists Pre-registration isn’t universally popular: there is much rending of white coats and grinding of molars over the issue. Opponents argue that it risks putting scientists in a creative straight-jacket. Although when respectable peer reviewed journals start publishing papers alleging the existence of extra-sensory perception based on … “Anomalous processes of information or energy transfer that are currently unexplained in terms of known physical or biological mechanisms” … then you have to wonder whether the creative juices maybe need a touch of reduction – oh, and the results of this experiment don’t seem to be replicable, bet they never saw that coming. So, what other group of people do we know who are given to making ad-hoc hypotheses, investing loads of money in them, and then ignoring the results while cherry picking specific successes in order to publicly claim that they were successful? OK, apart from politicians. Investing Feedback Investors have all of these faults, and a few more. If we truly wanted to become better investors, then we’d pre-register our hypotheses – including our expected timescales – and then measure our results against the results. Doubtless the outcome would frequently be embarrassing, but the evidence that we do have suggests that getting real feedback about our performance is the only way to improve predictive capability in complex systems like the stock market (see: Depressed Investors Don’t Need Feedback. Everyone Else Does ). The other thing this would do would be to force us to face up to the reality that we can be successful by luck and can fail through no fault of our own. In complex adaptive systems, we simply cannot predict every possible situation; we can only hope to be able to predict a little better than average. But a little better is enough to make a turn, so every percentage point improvement we can make is worth it. Commit and Document So I wonder if some enterprising developer out there fancies setting up a pre-registration website for investors keen to improve their returns, rather their personal status? Public commitment backed up by a positive rewards system has been shown to produce powerful results in a whole variety of situations. For example, in Tying Odysseus to the Mast: Evidence from a Commitment Savings Product in the Philippines , Nava Ashraf, Dean Karlan and Wesley Yin showed: “Commitment-treatment group participants have a 12.3 (9.6) percent higher probability of increasing their savings by more than 20 percent after six (twelve) months, relative to the control group participants, and an 11 (6.4) percent higher probability of increasing their savings by more than 20 percent, relative to the marketing group participants. The increase in savings over the twelve months suggests that the savings response to the commitment treatment is a lasting change, not merely a short-term response to the new product” I suspect that even a non-financial reward system based on peer support would facilitate uptake. HARK, hear… Avoiding HARKing is the future of the hard and the soft sciences. And, by analogy, as investors, if we don’t have hypotheses about what we’re investing in, then we’re simply the modern equivalents of astrologers. And, if we have hypotheses, we should write them down and test whether they’re right, not simply crow about the random successes and ignore the equally random failures. It’s worrying, of course, that this isn’t already the basic investing process. But to be honest it’s even more worrying that it doesn’t seem to be the basic scientific process. Genius and creativity has its place in all human activity – Kepler came up with his third law of planetary motion by mapping orbits to harmonic ratios , believing these to be a sign of heavenly perfection. But Kepler was a mad genius who happened to be correct, so here’s my hypothesis: relying on mad geniuses for humanity’s future and your family’s well-being is probably not prudent.

Using Momentum And Hedge Funds To Build A Better Portfolio

Welles Wilder revolutionized the investment world in 1978 when he developed the Relative Strength Indicator (“RSI”). RSI was one of several new technical indicators that helped individual investors move away from static “60/40” or “70/30” stock/bond asset allocations as trading commissions plummeted in the wake of discount brokerages displacing more expensive “full-service” offerings. Now, nearly forty years later, Berkeley Square Capital Management has a new take on RSI – and the traditional “70/30” allocation. The firm combines the two concepts, while adjusting RSI from a short-term indicator based on the past 14 days to a longer-term momentum indicator based on the past 12 months , and also adding hedge funds to the allocation mix – “50/30/20.” What’s more, Berkeley Square’s momentum strategy differentiates between the best and worst sectors within each asset class, taking advantage of reduced commission charges by rebalancing its portfolios as frequently as warranted to maximize risk-adjusted returns. Sector Breakdowns Rather than allocating 50% to the S&P 500, 30% to the Barclays Aggregate, and 20% to the HFRI Hedge Fund-Weighted Composite (“FWC”), Berkeley Square breaks each of the broad indices down into its composite sectors, and then assigns RSI rankings to each. The top five sectors from each asset class are then weighted to comprise the total “50/30/20” portfolio. Among equities, Berkeley Square looks at the S&P 500’s ten composite sectors: Energy Materials Industrials Consumer discretionary Consumer staples Health care Financials Information technology Telecommunications Utilities For fixed-income, Berkeley Square looks at the following Barclays Total Return indices: S. Corporate Investment Grade Intermediate Corporate Long U.S. Corporate S. MBS GNMA S. Long Credit S. Aggregate Government/ Credit And for hedge funds, the following HFRI strategy style indices are considered: ED: Merger Arbitrage EH: Equity Market Neutral EH: Short Bias Emerging Markets (Total) Equity Hedge (Total) Event-Driven (Total) Fund of Funds Composite Macro (Total) Frequency of Rebalancing The frequency of portfolio rebalancing should always be scaled to maximize risk-adjusted returns. According to Berkeley Square’s findings, equity holdings are best rebalanced monthly, which has historically yielded a return per unit of risk of 0.76 – compared to risk-adjusted returns of 0.56 for annual rebalancing, 0.59 for semi-annual, and 0.66 for quarterly. By contrast, bond holdings perform best when rebalanced annually, and hedge-fund holdings when rebalanced quarterly. Independent Returns Adding hedge funds to the asset allocation has slightly improved returns, historically, but more greatly improved risk-adjusted returns. As Modern Portfolio Theorist Harry Markowitz said, “Expected return is a desirable thing and variance of a return is an undesirable thing” – so rational investors should prefer more stable returns to more volatile returns, all other things being equal. From 1991 through 2014, the S&P 500 Total Return Index generated compound annualized returns of 10.18%, compared to the HFRI FWC’s 10.81%. But the S&P’s annualized standard deviation of 18.39% yielded a return per risk unit of 0.55, while the HFRI FWC’s much lower 12.11% annualized standard deviation yielded a 0.89 return per unit of risk. The Barclays Aggregate Index of bonds, by contrast, yielded much lower annualized returns of 6.39%, but with even lower annualized volatility of 4.97%, its return per unit of risk was the highest at 1.29. Putting it all Together What’s important, of course, is how the three asset classes act together, within a single portfolio: According to Berkeley Square’s research, the “50/30/20” portfolio – even without rebalancing – outperformed “70/30” with annualized returns of 9.58% from 1991 through 2014, compared to the “70/30” portfolio’s returns of 9.48% over that same time. More importantly, “50/30/20” outperformed on a risk-adjusted basis, with a return per unit of risk of 0.85 compared to the “70/30” portfolio’s 0.72. But what about when Berkeley Square’s dynamic reallocation system was followed? In this case, the “50/30/20” portfolio’s annualized returns were boosted to 10.92% with return per unit of risk of 1.16, besting even the long-only S&P 500 Total Return Index’s 10.18% returns, and with much less volatility. For more information, download a pdf copy of the white paper . Jason Seagraves contributed to this article.

VFORX: How A Target Date Fund Should Be Built

Summary The Vanguard Target Retirement 2040 Fund has a simple construction and a low expense ratio. Despite being a very simple portfolio, they have covered exposure to most of the important asset classes to reach the efficient frontier. The fund is mostly in equity but has materially underperformed the S&P 500 over because of a strong allocation to international equity. Lately I have been doing some research on target date retirement funds. Despite the concept of a target date retirement fund being fairly simple, the investment options appear to vary quite dramatically in quality. Some of the funds have dramatically more complex holdings consisting with a high volume of various funds while others use only a few funds and yet achieve excellent diversification. My goal is help investors recognize which funds are the most useful tools for planning for retirement. In this article I’m focusing on the Vanguard Target Retirement 2040 Fund Inv (MUTF: VFORX ). What do funds like VFORX do? They establish a portfolio based on a hypothetical start to retirement period. The portfolios are generally going to be designed under Modern Portfolio Theory so the goal is to maximize the expected return relative to the amount of risk the portfolio takes on. As investors are approaching retirement it is assumed that their risk tolerance will be decreasing and thus the holdings of the fund should become more conservative over time. That won’t be the case for every investor, but it is a reasonable starting place for creating a retirement option when each investor cannot be surveyed about their own unique risk tolerances. Therefore, the holdings of VFORX should be more aggressive now than they would be 3 years from now, but at all points we would expect the fund to be more conservative than a fund designed for investors that are expected to retire 5 years later. What Must Investors Know? The most important things to know about the funds are the expenses and either the individual holdings or the volatility of the portfolio as a whole. Regardless of the planned retirement date, high expense ratios are a problem. Depending on the individual, they may wish to modify their portfolio to be more or less aggressive than the holdings of VFORX. Expense Ratio The expense ratio of Vanguard Target Retirement 2040 Fund is .18%. That is higher than some of the underlying funds, but overall this is a very reasonable expense ratio for a fund that is creating an exceptionally efficient portfolio for investors and rebalancing it over time to reflect a reduced risk tolerance as investors get closer to retirement. In short, this is a very solid value for investors that don’t want to be constantly actively management their portfolio. Composition The fund is running almost 89% stocks to about 11% bonds, but over time the portfolio shifts to sell off stocks and hold more bonds as Vanguard assumes that investors nearing retirement will have a reduced risk tolerance. This portfolio strategy is the embodiment of what financial advisors seek to do for clients. Unfortunately Vanguard does not know the unique circumstances of every client, but for a .18% expense ratio they are doing a great job. Holdings The following chart demonstrates the holdings of the Vanguard Target Retirement 2040 Fund: (click to enlarge) This is a fairly simple portfolio. Only four total funds are included so the fund can gradually be shifted to more conservative allocations by making small decreases in equity weightings and increases in bond weightings. The funds included are the kind of funds you would expect from Vanguard. They are all solid funds with strong internal diversification in the holdings and low expense ratios. The Vanguard Total Stock Market Index Fund is also available as an ETF. The ETF version is the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). To be fair, Vanguard has a great reputation for running funds but not for coming up with creative names. I have a significant position in VTI because it carries an extremely low expense ratio and offers excellent diversification across the U.S. economy. Volatility An investor may choose to use VFORX in an employer sponsored account (if their employer has it on the approved list) while creating their own portfolio in separate accounts. Since I can’t predict what investors will choose to combine with the fund, I analyze it as being an entire portfolio. Since the fund includes domestic and international exposure to both equity and bonds, that seems like a fair way to analyze it. (click to enlarge) When we look at the volatility on VFORX, it is only slightly lower than the volatility on SPY. Despite similar levels of volatility, it has underperformed SPY. Generally investors will expect a target date fund to hold up better in a bear market and to fall behind in a bull market. For a portfolio with a target date as distant as 2040, investors have to expect strong equity positions will result in similar returns to the market. The real weakness demonstrated here was largely a function of the international equity markets underperforming the domestic equity markets. A Suggested Modification Even though this portfolio is designed for investors that are 25 years away from retirement, for the sake of lower annualized volatility I would like to see a slightly larger allocation to very long term treasury bonds. Since Vanguard is regularly rebalancing the fund it should be able to benefit from the strong negative correlation between the domestic equity market and the long term treasuries. To be fair, international markets have also been showing a negative correlation with long term treasury returns, so it really should be able to dramatically reduce the volatility without creating a very large drag on earnings. The benefit of the negative correlation with frequent rebalancing allows investors to be regularly buying low and selling high. Compared to most active investment strategies, a simple rebalancing plan that combines long term treasuries with domestic equities has been a very solid and remarkably simple strategy. Conclusion VFORX is a great mutual fund for investors looking for a simple “set it and forget it” option for their employer sponsored retirement accounts. It is ideally designed for investors planning to retire around 2040, but can also be used by younger employees with lower risk tolerances or older workers with higher risk tolerances.