The Observation Model is the Best Defense

July 20, 2015

7 minute read

The Blue Sky Taverna in Oia, Santorini, Greece

by Dan Varadi, Blue Sky Asset Management

Sometimes the decisions we make in everyday life are good case studies for making effective investing decisions. My wife and I recently travelled to Santorini Island in Greece where we stayed in the village of Imerovigli. During our trip we planned to hike to Oia – which has the nicest views on the island. The hike would take roughly two hours through a couple small towns and some isolated mountainous terrain beside the Aegean Sea.

When we awoke on the day of the hike the sky looked ominous with dark grey storm clouds as far as the eye could see. I was not enthusiastic about making the hike given the conditions, and politely suggested to my wife that we wait for another day when the weather is more promising. I was also concerned that we would be hiking without professional gear and traversing steep and narrow paths along the mountainside. We also did not have a map or a GPS and our only instructions we received from the locals were to “follow the path all the way until you hit Oia.” (Let me tell you that there was no such marked or obvious path.)

While we weighed in our decision, my wife decided to ask one of the staff at the hotel for their opinion. Our local “expert” assured my wife that the “forecasts” called for it to rain starting late that evening and that we should be safe to hike. Naturally, our local expert’s recommendation seemed more authoritative and impressive to my wife than my primitive observations. We argued a bit, but in the end I decided to give in. After all, how bad could it be? Before leaving I asked the same staff member for an umbrella.

We set out on our journey and made it to the narrow path high above the sea when it started to rain lightly. The trail was steep and covered with volcanic rock which was smooth and slippery when wet–making our hike much more perilous. At this point we were close enough to the previous town to seek shelter so we stopped to discuss our options, I wanted to go back and my wife wanted to press on. Another couple was hiking just behind us debating the same decision. As we debated our situation the other couple managed to get a hundred yards in front of us. My wife complained, pointing to the other couple that if we hadn’t stopped to argue we would much farther ahead. Being a nonconformist, I did not care much about our relative circumstances. However, like any good husband does, I gave in and we continued on in what was now a full-fledged downpour. The final leg of the trip was extremely dangerous but we managed to pull through. We carefully descended the last part of the mountain and huddled together under a patio of a small hotel with several other European tourists that had been stranded. There we were, sitting together at a picnic table considering the weather situation in Greece with our new tourist friends. With a stroke of unforeseen luck, we all managed to catch a bus to Oia. When we arrived it was still raining and so we decided to step into the first restaurant we saw to seek shelter and grab some lunch (and some well-deserved adult beverages). The restaurant? Blue Sky Tavern!

Lessons to Learn for Investors

The biggest mistake we made was to pay attention to weather forecasts and “expert advice” instead of focusing on the simple observation that the weather looked too risky to make a long trip. In the mathematics of option pricing high volatility plus a longer time period equals greater risk. The “observation model” of looking at the current trend is the most reliable tool that we have to make decisions in financial markets. If the trend (or momentum) is favorable then you can hold a given position in a market, if the trend is down then you should seek the safety of a defensive assets such as treasury bills. This is supported by overwhelming evidence from academic research spanning over several hundred years and dozens of different markets. Furthermore, some of the most successful portfolio managers in the world use similar rules. We never know what is going to happen when the trend turns down, but the cost of being exposed to dangerous market conditions can wreak havoc on your portfolio.

The second mistake that we made was to pay attention to other people when making our decisions. My wife could not bear to watch the other couple get further ahead while we were being cautious; this made the cost of managing risk too difficult to bear. Investors often abandon a sound and risk-managed approach during bull markets when their friends (who throw caution to the wind) are outperforming. Human beings are social animals, and we tend to herd together. It is not natural for a single person to go against the direction of the crowd. This behavior is what drives the success of several profitable investment anomalies that take the opposite side of the trade such as value or low-volatility. The smart investor that wants to succeed should focus on achieving absolute returns using a sensible strategy across a full market cycle that includes both bear and bull markets rather than comparing themselves to their peers.

It is also important to consider what behavioural economists call “hindsight bias.” Things look less risky in the rear view mirror- especially when they turn out favorably. Looking back at our hike everything turned out just fine, and my wife and I had quite an adventure. Of course, if we repeated the same trip a hundred times under those circumstances, some of our trips could have put us in a dangerous or perilous position. Had we waited for blue sky conditions to make the journey, we would have had a much easier hike and also more opportunities to take pictures along the way. This is similar in some ways to the recovery after 2008 that made investors who “stayed the course” all the way through the crisis into the current recovery feel as if they made a smart decision. But this is just a single case example–like one path out of hundreds of possible paths that the market could have taken. Markets like Japan have not yet recovered from their prior highs and serve to broaden our sample of possible outcomes. Had investors simply followed the trend in 2008 (or looked at the relative return of the market in relation to a low risk alternative like t-bills), they could have enjoyed the relative safety of being on the sidelines for much of the downturn and reinvested their capital when things looked sunnier at some point in 2009. Furthermore, they could have spent their mental energy on more productive pursuits than following the daily news headlines and experiencing the gut-wrenching daily turbulence.

We believe that the observation model is the best defense for investors. Trust in what is actually happening rather than what “should” happen. If you turn on the cold water tap at a hotel and it is boiling hot, should you still wash your hands on the premise that you theoretically turned the “correct” tap? If you are an economist, sadly the answer is “yes”. If you are a smart investor, the answer should be “no.” Better to wait for the temperature to either change or try the other tap. We also believe that it is better for quantitative models to make the final decision rather than a human being; a human portfolio manager is much more likely to succumb to peer pressure in making decisions (much like I did with my wife). This is especially true when conditions are stressful and the information available leads to uncertain conclusions. In contrast, using a quantitative trend-following approach leads to “black and white” decisions which save investors from themselves in the the most in the most difficult times. This quote from Jim Simons of the spectacularly successful hedge fund Renaissance Technologies sums up our quantitative investment philosophy: “If you do fundamental trading one morning you feel like a genius, the next day you feel like an idiot….by 1998 I decided we would go 100% models…we slavishly follow the model. You do whatever it [the model] says no matter how smart or dumb you think it is. And that turned out to be a wonderful business.”