Reality Check

EngEvery advisor who works with individual investors has stories to tell about engineer clients — or would-be clients.  They want to understand every detail about their investments and prospective investments.  That’s a good thing, of course, but with engineers the explanation process can take an extraordinarily long time and try the patience of the advisor.

Yet the real difficulty — or so it seems to me — is the typical mindset of engineers.  In my experience, they have particular difficulty dealing with uncertainty.  They tend to think that there is “an answer” out there.  They aren’t often comfortable with probabilistic solutions.

So I was not surprised last week when I heard an engineer talking about an investment strategy available by computer program (of course) created by another engineer that appears to track over 20 years at about 20 percent annualized.  That the approach is deemed proprietary gives it the added caché of “hope and exclusivity,” which is great for sales but does nothing for performance.

Without knowing the details, I have no doubt (because I have seen many such programs) that the approach was data-mined based upon historical prices and not based upon actual returns.  In other words, historical data was mined for a pattern that “worked” up through the present.  After much effort and tweaking, the approach is honed and back-tested to suggest the hope of 20 percent annualized going forward.  But, significantly, prospective and hypothetical returns are never the same as actual cash-money returns.

With many of these approaches, there isn’t any clear agency — the data that has been mined simply shows an apparent pattern that seems to have led to the promised land.  Because we are pattern-seeking creatures, we often perceive the existence of an actionable pattern where none exists, especially if and when we lack control.  Of course, we are most definitely not in control of the markets.  Thus we see patterns where randomness reigns. In such instances, the proffered approach simply works until it stops working (because there is no agency involved).

If and when there is a real and actionable pattern, these success of these approaches still tends to disappear.  Obviously, when the underlying circumstances change, the pattern may no longer be valid.  It is also axiomatic in the investment world that as an approach or trade becomes more popular, it suffers from falling expected returns, higher prices and rising correlations.  In other words, good trades get crowded and their advantages tend to disappear.  This crowding happens because success begets copycats as investors chase returns. That’s why I can be so sure than approaches like the one pitched by the engineer haven’t seen a lot of actual money behind them over a significant period of time.  When that happens, at some point (usually sooner rather than later), such trades become crowded and no longer an answer, much less the answer. 

To look at the impact of such a trade, it can help to think about the scale of what is at stake.  A return of 20 percent annualized over 20 years would mean that your money had multiplied nearly 39 times. In other words, $1,000,000 would have turned into nearly $40 million.  Since that level of consistent, long-term growth is gigantic — the S&P 500 has averaged less than half that historical level of return (roughly 9.4 percent annualized) — trades like that would not and do not go unnoticed.  Success of that magnitude would have been cloned and crowded out long before 20 years were up.

The engineer’s quest for an investing holy grail is yet another example of our tendency to chase the sizzle and ignore the steak (or at least the meat loaf) that the markets offer.  Much money has been wasted and enormous opportunity costs sunk on such nonsense.

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19 thoughts on “Reality Check

  1. The wheels don’t randomly fall off your car because engineers won’t accept that. On the other hand, I wouldn’t let an adviser engineer anything considering how often the wheels fall off your product.

  2. I guess I wouldn’t be the first or last to point out that the same rear-facing biases apply to any analysis of the relative success of passive investment strategies?

    • That depends upon the definition of “passive” used. By the most common usage, passive strategies provide market returns less their cost. There are no rear-facing biases in that context.

      To be clear, however, any approach or strategy can work. A few persist (such as value, small cap, momentum and low vol) while most do not. Those that do not persist can and sometimes do work for a period. I am not knocking those strategies. But I *am* expressing my skepticism that an approach providing 20 percent annualized can do so consistently and over the long-term (e.g., 20 years).

      Thanks for reading.

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  4. Bob,

    Just a quick note to say I really enjoy your blog. You always have great insights and take a reasonable and measured approach to what it takes to succeed as an investor.

  5. Try a mix of 30 assets, global, dividend growing companies with low volatility, CAGR between 11-14%, combined with energy and MLP, short and interm. bonds, world bond, LQD, a certificate deposit with 4% yield and a renting business of some farm lands and i’ve been making 14% a year for the past 10 years. It’s all about diversification around 25-35 assets, dividend growing, compounding, reinvesting fresh money, low correlation, and enjoy the ride in the good and the bad moments. I like to keep it short and simple and it works for me and my family.

    • If you are really doing that consistently, you are in the wrong business. Roughly one-half of one percent (83) of the over 13,000 funds in the Morningstar data base have achieved that level of performance over the past ten years and the few that have are almost all very high risk emerging markets funds. You have even crushed Warren Buffett, whose Berkshire Hathaway earned an average of 10.95 percent per year from 2003-2012. Do that for real with other people’s money and you would be making millions of dollars per year.

      I also hope you’ll forgive me for being skeptical about your claims of success. Research has conclusively established that what people think and claim their investment returns are and what those returns actually are have — quite literally — *nothing to do with each other*. Nearly everyone says they have done far better than they actually have. See, for example, this study: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1002092

      Thanks for reading.

      • Please, by all means be skeptical, i can understand you, but i can show you my portfolio if it helps, i keep a record on seeking alpha. And yes, i am in the right business, probably in the wrong country though, i’m a Family Doctor in Portugal and my wife a Phd Teacher at a Portuguese University.

      • And she is my best side kick when it comes to investing since she her phd is in logistics, optimization and operations management! :)

  6. Proper engineering requires the understanding and acceptance of uncertainties. In engineering we have to account for tolerances, deviations, contamination, and extremes of conditions. Nothing is certain, and perfection is nothing more than an idealistic concept. Anyone that cannot grasp this should not be an engineer, and certainly should not try to predict the markets.

  7. A different way of saying that 20% annual returns are not likely is due to scalability. You can manage a $100k portfolio much easier than a $100 million or $100 billion portfolio. When you manage the $100k portfolio, you can take positions in $100 million market cap companies that will move the needle on your return. When you manage $100 billion, how many US equities can you own that will substantially change your overall return? The answer is not many. If you are running a long only equity fund, by definition it has become an index fund. Maybe you can give it a slight value tilt by having equal weighting instead of market cap weighting, but that will not get you to 20%.

    I have seen a lot strategies fall apart when the manager extrapolated the scalability. They converge to index like returns.

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  9. In philosophy of science it is well-known that human behavioural “laws” nearly always lack the reliability of laws of nature, not least because human agents – unlike non-conscious material objects or unreflective animals – can understand, react to, and consequently alter the applicability of laws. Examples in finance abound of predictions (of share or economic trends) that are self-fulfilling (e.g. Go away in May) or self-refuting, as people react to the predictions. However, short of Holy Grails, avoiding common fallacies can give some investors an edge.

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