Reality Check

by Robert P. Seawright, Above the Market

June 19, 2013

Every 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.

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