In What Works on Wall Street: A Guide to the Best Performing Investment Strategies of all Time, money manager and market researcher James O’Shaughnessy tells you why models win.
“Models never vary. They never fight with their spouse, are hung over, or get bored. They don’t favor vivid, interesting stories over reams of statistical data. They never take anything personally. They don’t have egos. They are not out to prove anything. If they were people, they would be the death of any party.”
Ok. It’s unlikely a Supermodel is going to be the death of the party. But when it comes to investment models … well, they’re just plain boring!
Investment models are as exciting as watching paint dry. There’s no hot story, no new drug discovery, or winning sales contract to talk about. Models require investors to do the same thing over and over no matter what resulted from the last trade.
Models Just Plain Win!
Models are persistently successful. They continue to win. They win “because they reliably and consistently apply the same criteria time after time” says O’Shaughnessy.
You see … gambling and investing are similar. They both involve probabilities. Both involve placing your money at risk with the hope of getting more money back than what was risked.
And both can make your hard earned money vanish if you bet wrong. So what’s the difference and why should you care?
The difference boils down to a simple concept—mathematical expectation. And the reason you should care about this is because it tells you how much profit (or loss) you can expect—if you follow a specific strategy long enough.
There are only two factors that influence mathematical expectation: (1) the probability that your bet will either be a winner or a loser, and (2) how much you win on winning bets and how much lose on losing bets.
That’s it! But unfortunately, most investors don’t know how to implement mathematical expectation into their investment strategy. Again … it’s boring.
But buying a stock just because you think it will go up … or because it was recommended by your advisor or on CNBC … is not a winning strategy. Look close enough and the vast majority of what is passed off as advice is simply nothing more than conjecture or opinion.
The reason I advocate systematic investment models is because they provide the ability to formulate mathematic expectation. These Supermodels formulate a clear plan to win the investment game.
Let me provide a “Supermodel” example.
I run many systems but one of my favorites is a relative strength system applied to a basket of Emerging Market ETFs. The system is extremely simple- each month I purchase the top two ETF as ranked by relative strength.
Since 2003 the model has produced an astounding CAGR of over 30 percent. To me … this is “Super” … especially when the S&P 500 returned 6.00 percent during the same period.
But even more important than the return is how I know the median win was 5.51 percent while the median loss is -2.35 percent. That means when I won … I won twice as much more as when I lost.
I also know from the boring supermodel that 63 percent of the time the trade signals will produce a win. This is the kind of information that gives investors confidence—regardless of the investor’s experience or ability—and because the system has positive mathematic expectation.
Small Cap Stock Model Profits
In the coming weeks I will be sharing a series of articles on how to use a systematic approach to select and manage a portfolio of small-cap stocks.
While most investors prefer to entertain themselves with only hot stock stories, I will demonstrate how you can take a stock with a story and make sure you win with a positive mathematical advantage!
For profiting with models in 2012, click here for more winning models at the Portfolio Café!