Asymmetric Investment Returns - Insights into portfolio management beliefs, strategies, and tactics that aim to create a positive imbalance between risk and reward

There are many paradoxes in investment management as well as other things in life. I’m always noticing them, drawing distinctions, and comparing and quantifying them.

I find that many things initially seem to be in conflict. On the one hand, we need to quantify things to determine probability and to make good decisions. On the other hand, there are many issues with quantifying and discovering the real probability. Those who do it best are well aware of the paradoxes. As with anything, doing something doesn't necessarily mean you do it well. Once we figure out what to do, we have to do it well. 

On this Super Bowl Sunday, all the math and science is present, though even those who quote it the most seem unaware of how it works. Ah, there is another paradox. For everyone I know who doesn't have any real understanding of probability and statistics at all I probably know another whose mind is full of so much math they are unable to apply it in the real world. I learned my most useful math on my own and I think that’s been an advantage. First, I did it because I wanted to, not because I needed a grade. Then, I really needed to know it to apply it in my portfolio management systems, not just to score on a test. That may be a disadvantage for those who learned even at the most Ivy of leagues. Intentions can make all the difference. 

The paradox today is about how college football ranking leads to a Super Bowl, or not.

Earlier this week I pointed out how the National Signing Day for college football gets a lot of press based on the rating agencies. The school who happens to attract the most top ranked recruits will get the most media attention for having the top ranked class. Yet, the ranking is based on what another organization believes the rating should be. It has nothing to do with a individual programs own proprietary rating of how they believe that player may fit within their program. The paradox is; on the one hand, the rating agencies quantify the talent and skill and that's at least the right intent, on the other hand their methods may not actually be accurate or useful. Or, it may simply not be useful to an individual football program. 

Waiting around for the Super Bowl today, I thought I’d check to see how football programs ended up on Rivals.com recruiting class ranking. Steve Megargee, a Staff Writer at Rivales.com wrote a excellent story titled "Super Bowl rosters filled with underdog stories". (I just noticed that he is up the road in Brentwood, Tennessee). In it, he said:

Half the Patriots who came up during the Rivals.com era weren't five-star, four-star or even three-star prospects. Eleven of those 36 players signed with FBS programs as two-star recruits. The remaining seven either began their college careers as walk-ons or enrolled at non-FBS programs. 

Now they're heading to the Super Bowl.

So even though the Patriots enter this game as slight favorites, they actually are the Super Bowl team with the most underdog stories.

Judgemental heuristics are a "rule of thumb". People naturally want to make quick decisions and judgements, so they draw from what they know. If we know enough of the right things, we can have 'expert intuition' and our 'rules of thumb' may be useful, at least initially. 

I enjoyed the article because it pointed out that many of the players on the field in tonight's game weren't ranked as top recruits in the early stages of their career. Still, you may consider that the title of the article still called them "underdogs". You can probably see how judgemental heuristics can stick with us that way. Would we consider them an "underdog" just because some rating agency hadn't ranked them high so many years ago?

There are no underdogs in tonight's game. That's why they all get a ring.

His tweet was right on:

Patriots get five-star results from players who were two-star recruits (or less).

Asymmetric information is a condition in which at least some relevant information is known to some but not everyone. Information asymmetry causes markets to become inefficient, since all the market participants do not have access to the information they need for their decision making processes. The type of information may have nothing at all to do with news and everything to do with the process and tactics of portfolio management. For example, one persons knowledge may be limited to an article they read that said buying when the price is above a moving average and selling when it's below a moving average is good. Another may believe the only way to go is to get allocated, then sit there and take it. Another may have tested all the parameters imaginable, from a 1 day moving average to a 5,000 day moving average and anything else you can come up with. They probably each have very different beliefs and frames of reference. 

The funny thing about most economic theory is they assume the rational actor. That is, they assume people make the rational choice. You probably know better, but let's assume we all can be expected to make rational choices.

Suppose you are a Professor at a university earning a reasonable salary doing research. Let's even go beyond individual greed and say you have a family, church, and charities who could use the money if you were more able to donate. 

Suppose you completed a research study and you discovered an edge for trading. For example, it could be some inefficiency about the market likely caused by cognitive bias or it could be some system for managing risk that allows you to focus on the velocity of profits. 

Knowing that the more people using it the less of an edge it may have, would you publish a paper about it? or would you instead try to earn millions from it's edge? What is the rational choice? Send me your answer and thoughts via the comment button below.

This Friday, April 15th, Ayn Rand's "Atlas Shrugged Part 1" will finally appear on the big screen. We don't know in advance if Hollywood will be successful making her influential book into a movie, but I'm sure to go find out. The official website says:

A powerful railroad executive, Dagny Taggart, struggles to keep her business alive while society is crumbling around her. Based on the 1957 novel by Ayn Rand.

One of my favorite quotes about personal responsibility and individualism is This is John Galt Speaking. Though admittedly it may sound a little harsh to some, that's sometimes what it takes to get a point across.

This is John Galt Speaking:

Happiness is not to be achieved at the command of emotional whims. Happiness is not the satisfaction of whatever irrational wishes you might blindly attempt to indulge. Happiness is a state of non-contradictory joy—a joy without penalty or guilt, a joy that does not clash with any of your values and does not work for your own destruction, not the joy of escaping from your mind, but of using your mind's fullest power, not the joy of faking reality, but of achieving values that are real, not the joy of a drunkard, but of a producer. Happiness is possible only to a rational man, the man who desires nothing but rational goals, seeks nothing but rational values and finds his joy in nothing but rational actions.

Just as I support my life, neither by robbery nor alms, but by my own effort, so I do not seek to derive my happiness from the injury of the favor of others, but earn it by my own achievement. Just as I do not consider the pleasure of others as the goal of my life, so I do not consider my pleasure as the goal of the lives of others. Just as there are no contradictions in my values and no conflicts among my desires—so there are no victims and no conflicts of interest among rational men, men who do not desire the unearned and do not view one another with a cannibal's lust, men who neither make sacrifices nor accept them.

The symbol of all relationships among such men, the moral symbol of respect for human beings, is the trader. We, who live by values, not by loot are traders, both in manner and spirit. A trader is a man who earns what he gets and does not give or take the undeserved. A trader does not ask to be paid for his failures, nor does he ask to be loved for his flaws. A trader does not squander his body as fodder, or his soul as alms. Just as he does not give his work except in trade for material values, so he does not give the values of his spirit—his love, his friendship, his esteem—except in payment and in trade for human virtue, in payment for his own selfish pleasure, which he receives from men he can respect. The mystic parasites who have, throughout the ages, reviled the trader and held him in contempt, while honoring the beggars and the looters, have known the secret motive of the sneers: a trader is the entity they dread—a man of justice.

The official movie website (including a trailer): http://www.atlas-shrugged-movie.com/

Useful knowledge is new information that changes the way we think and do things. Useful knowledge improves on how we make choices and conduct our lives. If we are to gain new useful knowledge, we necessarily have to debate and be open to new ideas, new information not previously known to us. I have learned the most from my adversaries: those people who completely disagree with what I believed at the time. We learn the most when we debate different views. The scientific method is to disprove a belief with empirical evidence. So, if you are a person who avoids conflict and debate, please know that without it we make no progress. We cannot evolve and gain new useful knowledge without a discussion of different views. Many things cannot be proven, but only disproven, so if we want to evolve with new useful knowledge we have to take a hammer to your beliefs to see if you can break them.

Many great men and women before us have did just the same.

In his Nobel Prize biography, Daniel Kahneman looks back on his deep collaboration with Tversky and calls for a new form of academic cooperation, marked not by turf battles but by "adversarial collaboration," a good-faith effort by unlike minds to conduct joint research, critiquing each other in the service of an ideal of truth to which both can contribute.

Fama and French are the fathers of Efficient Market Hypothesis. EMH is a theory that all information is priced in to stocks, so you cannot outperform an unmanaged index. Interestingly, Fama and French are consultants to an index fund company: Dimensional Fund Advisors. Many investment advisors and financial planners use EMH as their reason to passively allocate to indices - a high risk strategy since it exposes investors fully to the possibility of loss. At Shell Capital, we do not believe the market is fully efficient. If the market were efficient, there would be no trends. EMH suggests that trends do not exist. Instead, we believe the cognitive biases cause investors to make errors like anchoring to prior information and they are slow to factor in new information (Conservative Bias), so prices under-react to new information and prices drift slowly in the direction of the information. In addition, trends often move much further than fundamentals warrant because herding causes over-reaction.

Below is a video of Fama, French, and some others talking about Efficient Market Hypothesis. We are fascinated that so many investors and financial planners recommend such a strategy. That is especially true since return factors such as the persistence of systematic price trends (momentum) disproves the theory that markets are efficient. To be sure, below is a quote from Fama, Eugene F. and French, Kenneth R., Dissecting Anomalies (June 2007). CRSP Working Paper No. 610.

 "The premier anomaly is momentum (Jegadeesh and Titman (1993)): stocks with low returns over the last year tend to have low returns for the next few months and stocks with high past returns tend to have high future returns. Like the  patterns in average returns associated with net stock issues, accruals, profitability, and asset growth, return momentum is left unexplained by the three-factor model of Fama and French (1993) as well as by the CAPM."

Eugene Fama and Kenneth French are known for "Efficient Market Hypothesis". Many investment advisors and financial planners who take a passive approach often anchor to the hypothesis that the market reflects information too quickly for them to exploit, so they may as well buy and hold a group of index funds. Supporters of EMH continue to change the definition of what makes a market efficient, making it difficult to falsify. However, since the first EMH study was released nearly forty years ago, new knowledge has falsified the hypothesis that markets efficiently reflect new information (news). There is at least one anomaly they admit is pervasive: Momentum. Momentum can mean many things and certainly is applied in different ways by different investors, but it basically means buying stocks that have recently gone up (over the past 3 - 12 months) and selling (or at least avoiding) those that are going down. That may sound familiar, since it is a strategy used by Shell Capital Management to achieve the results you see in our separate managed account program, the Asymmetry Investment Program. We, of course, agree that momentum is a return anomaly and its robustness is at least one factor in creating the results you see in our Performance Composite. However, it takes more than just a price momentum ranking system to create those kind of results. Absolute returns and an asymmetric risk/reward profile seen in our investment program cannot be achieved by relative price strength or price momentum alone; it requires great skill at portfolio management and that involves an edge in risk control. With that disclaimer out of the way, we share some of the comments from "Dissecting Anomalies" a paper by Fama and French that studies some of the anomalies like Momentum.

The following quotes are taken from: Fama, Eugene F. and French, Kenneth R., Dissecting Anomalies (June 2007). CRSP Working Paper No. 610.

From the abstract:

 "...momentum is pervasive".

Page 1:

"The premier anomaly is momentum (Jegadeesh and Titman (1993)): stocks with low returns over the last year tend to have low returns for the next few months and stocks with high past returns tend to have high future returns. Like the patterns in average returns associated with net stock issues, accruals, profitability, and asset growth, return momentum is left unexplained by the three-factor model of Fama and French (1993) as well as by the CAPM."

“…return momentum is left unexplained by the three-factor model of Fama and French (1993) as well as by the CAPM.”

Page 3:

 “We find that, at least in the extremes, net stock issues, accruals, and momentum produce strong abnormal returns for microcaps, small stocks, and big stocks. For net stock issues and accruals, however, there are chinks in the armor.”

Page 4:

"The two clear winners, in terms of strong average regression slopes for all size groups, are net stock issues and momentum."

"We also argue that the observed relations between average returns and the anomaly variables (positive for momentum and profitability, negative for net stock issues, accruals, and asset growth) are at least roughly in line with the valuation equation."

Page 9:

"Which anomalies produce strong average hedge returns for all three (micro, small, and big) size groups? The clear winners in Table II are net stock issues, accruals, and momentum."

"Finally, momentum sorts produce strong positive average VW and EW hedge returns for all size groups."

"Our momentum results complement those in Hong, Stein, and Lim (2000)."

"Since stock issues, accruals, and momentum produce large average EW and VW abnormal hedge returns in all size groups, at least in terms of hedge returns, these three anomalies are pervasive."

Page 11:

"Which anomalies are present in all size groups and produce returns that vary systematically from the low to the high ends of the sorts? Momentum satisfies both criteria. Abnormal VW momentum returns are strongest for microcaps and weakest for big stocks, but they are impressive in all size groups, and they increase rather systematically from strongly negative for extreme losers to strongly positive for extreme winners. EW momentum returns in all size groups also vary smoothly from losers to winners."

page 16:

 "...among the remaining variables, only net stock issues and momentum show strong marginal explanatory power in all size groups in the regressions...."

Source: Fama, Eugene F. and French, Kenneth R., Dissecting Anomalies (June 2007). CRSP Working Paper No. 610. Available at SSRN: http://ssrn.com/abstract=911960

As a follow up with yesterday's comment "Drawing the Line in the Sand for the Stock Market: A Look at the S&P 500 Index Trend "... so far, so good. As you can see in the chart below, the February lows held today. The stock indexes were down 2-3% most of the day. But by the day's end, the selling pressure dried up. The index closed very close to yesterdays closing price. For those who are looking for a reversal up, you "may" be in luck soon. I say this because of today's price action.

If you look at the blue arrows, those are called a "Hammer" on a candlestick chart. The Hammer is a common bullish reversal pattern that forms after a decline. It's common enough that a Hammer marked the February low. In addition to a potential trend reversal, hammers can mark bottoms as it did in February. The height of the candle shows the wide high to low price range that traded today as sellers drove prices lower during the session but buyers stepped in at the end of the day and took over. Hammers are similar to selling climaxes. We'll want to see confirmation, which could be a gap up in the days ahead. For prices to reverse back up, the selling pressure that drove it down simply needs to be overwhelmed by buying demand. For that to occur, prices have got to get to a low enough level to attract buying interest.

 Chart courtesy of eSignal Pro

Times like these can be very difficult for the passive investors who remain fully invested all the time. They are caught in a loss trap and don't know for sure how long it may last or how deep the losses may get. If the current price range does not hold support (the red highlighted area on the chart) and reverse up, the pressure will get stronger and stronger as their losses mount. There is also a possibility that stocks could reverse up for a few days or weeks and then reverse down to eventually break the February lows. From that point, it could keep going to the March 2009. Anything is possible. This is why, at Shell Capital Management we actively manage our risk by increasing and decreasing exposure to the possibility of loss... When prices are peaking out or start reversing down and volatility is rising, we exit weak positions systematically to reduce our exposure to loss. The market isn't the risk. The risk is the exposure. If we have no exposure, we have no risk. Our risk control system is a huge advantage for us. It allows us to control our risk to a maximum amount we're willing to take as we aim for capital gains. You see, we can't fully hedge or eliminate our risk all the time and expect to earn a profit. We aren't unwilling to take any risk at all. We must employ "some" risk in order to have profit potential. In order to earn a profit, we need exposure to some degree at some point. What we do differently is control the "degree of exposure" and the "point". We only want exposure when the odds are overwhelmingly in our favor. We do it by buying and selling things...

As it turns out, we have something in common with many of the most famous investors in the world. The following statement was written by Warren Buffett in a 2003 "Letter to the Shareholders of Berkshire Hathaway".

 

When we can’t find anything exciting in which to invest, our “default” position is U.S. Treasuries, ... Charlie and I detest taking even small risks unless we feel we are being adequately compensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton.*

It appears that Mr. Buffett, like us, has an objective of absolute returns ...

We like avoiding large losses on our portfolio (as defined by -15% or more). We like not having to "worry" if this Hammer is indeed a setup for a reversal, or not. We reduce our exposure to loss to an acceptable level and then go with the flow...

 *Source: http://www.berkshirehathaway.com/letters/2003ltr.pdf