Computer-modelled portfolio returns will outstrip the experts
In a host of endeavours, quantitative models are surpassing human experts in decision accuracy. Software programs that predict the location and frequency of criminal activity have repeatedly beaten the forecasts of experienced police analysts. Models that assess credit worthiness have proved so superior to human judgment that they are now used across the credit card and mortgage industries. Several studies have found that certain statistical models do a better job of predicting academic performance than admissions officers.
The superior accuracy of quantitative models is extending into realms undreamt of a few years ago, including medicine and law. Models have proven more accurate than doctors in forecasting survival rates for patients with coronary heart disease. A statistical model has even proven more accurate than legal experts in forecasting the decisions of the U.S. Supreme Court.
The ability of models to outstrip experts derives from their inherent advantages. Good models are constructed through rigorous statistical testing using appropriate data samples that ensure their findings are valid at a defined level of confidence. Experts, on the other hand, use subjective judgment based on diverse criteria and, hence, are prone to a higher error rate. Overall, models are consistent in their application; experts are influenced by emotion and extraneous variables.
It shouldn’t be a surprise then that a good investment model outshines the typical investor.
Joel Greenblatt, author of The Little Book That Beats the Market
and Managing Principal of Gotham Asset Management, is behind For- mula Investing in the U.S. This online portfolio management service offers investors separately managed accounts that can choose from a list of top-ranked stocks selected on the basis of well-defined formulas.
Investors can either “self-manage” their accounts by initiating their own buys and sells from this stock list using the firm’s trading guidelines or have it “professionally managed” based on a predetermined trading model that buys and sells, at preset intervals, from the same formula-generated stock list.
Over the first two years of its operation, Mr. Greenblatt reported that the self-managed accounts delivered a handsome 59.4% cumulative return. However, over the same period, the professionally managed accounts — buying and selling off the same list of stocks in the preplanned model — returned a sizably richer 84.1%.
It seems that individual investors, once given the freedom to vary from the “model,” promptly went about shooting themselves in the proverbial financial foot. Many didn’t buy the biggest winning stocks — stocks that were often very cheap but had major business problems or industry challenges.
Mr. Greenblatt suspects these investors shied away from these stocks because of these issues. Some investors, after a disappointing bout of performance, moved to cash or quit updating their stock selections. Finally, some investors postponed buying until after bouts of good performance, a “buy higher” approach that eroded returns.
None of this behaviour is surprising to seasoned investment professionals. The returns of investors as a group routinely underperform the mutual funds in which they are invested. Emotionally driven buying high and selling low wreaks havoc with performance.
Sophisticated investors such as pension plans have known for decades that defining their own long- term “asset mix model” is vital to success. This model sets out their allocations to the major asset classes so they can stay on course, in good markets and bad.
Unfortunately, many investors, including wealthy ones, gloss over the critical step of thoughtfully defining the right long-term asset mix for their risk profile and financial situation.
It is so easy to resist the needed discipline of an asset mix model when stock prices are skyrocketing, top equity managers abound and suave market experts are offering free tips in every media outlet. The sobering inevitability of the next painful bear market means there will be plenty of time for regrets.