Competing Ideologies

One of the most difficult aspects of investing is that to create a successful investment process you have to get used to the fact that you’re bound to have competing ideologies at times depending on where we are in the investment cycle.

Take buy and hold as an example. I like to say that any type of buy and hold strategy only works if you’re able to both buy and hold when markets crash.

And while it can be difficult to follow your plan during a market crash you have to have a completely different mindset during a bull market. To practice buy and hold (or some variation of it) you really have to be a practicing contrarian when stocks are going down and a practicing trend-follower when stocks are going up. You have to be willing to use two competing schools of thought at different times. That’s not always so easy to pull off.

In many ways this is similar to the two most well-known quantitative investing strategies – value and momentum. Each of these strategies seeks to take advantage of over- and under-reactions made in the market, but in very different ways. With a value strategy, stocks that have performed poorly for one reason or another become cheap as investors over-react by selling first and asking questions later. With a momentum strategy, stocks that have done well recently tend of continue doing well for short periods of time because investors initially under-react. Value and momentum each rely on mean reversion, but in different ways and over different time frames.

Both value and momentum have historically been shown to work well as stand-alone strategies. But these two contrasting ideas actually work very well when you pair them together because they can make up for each other’s deficiencies during certain market environments. Therefore, diversifying these two return streams helps increase risk-adjusted returns.

But the implementation of a value/momentum combination will never work if the investor isn’t willing to accept that there are two schools of thought that can complement one another. (Read more on the advantages of combining value and momentum from the team at Alpha Architect.)

Really this idea of dealing with competing ideologies will be true of any successful long-term investment strategy. At certain times you will have to be willing to take an uncomfortable stance. Sometimes that means going against the crowd. Other times it’s going to mean going along with the crowd.

You have to be intellectually honest with yourself to be able to pull this off.

Lately it seems that every investor would like to be considered a contrarian that goes against the herd. It’s an intellectually stimulating position to be in. I think an actual contrarian strategy can be one in which an investor is willing to combine different approaches and consistently follow them throughout various points in the market cycle to manage risk and improve long-term performance.

Further Reading:
Avoiding the Extremes
Don’t Take This Personally

Here’s the stuff I’ve been reading lately:

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What's been said:

Discussions found on the web
  1. innerscorecard commented on Mar 26

    Two points of interest:

    1. It’s interesting to think that you really do NOT want to be a contrarian all the time, but should instead only be one some of the time. If you are a contrarian all the time, that means you are always wrong! Obvious, but I liked the way you stated it.

    2. Combining strategies seems to make sense, but it seems that in practice there is the huge risk of implementing it incorrectly and thus becoming the worst thing – the hot money that is chasing the strategy that just worked in the most recent past period, just when it stops working. So you could actually be doing the worst thing at any given time, not the best! Obviously the important thing would be being systematic (maybe to the degree of being completely mechanical).

    • Ben commented on Mar 27

      I think there are actually many people that don’t understand that you can’t be a contrarian at all times. Eventually the herd has to agree with your contrarian position.

      I agree you have to be careful which strategies you combine. There’s always the possibility of over-diversification and redundancies within your portfolio.

  2. John Thees commented on Mar 27

    Don’t you automatically combine these strategies while accumulating wealth if you take a disciplined approach to investing and no matter which way the market is going, dollar cost average into a simple index funds portfolio consisting of, for example, Vanguard’s Total Stock Market Index Fund, Total International Stock Index Fund and REIT Index Fund?

    • Ben commented on Mar 27

      Exactly. Any diversified portfolio will always have competing interests. One of the best and worst parts about an asset allocation approach.

  3. Scott Boone commented on Mar 27

    This smacks suspiciously of “market timing,” which experienced investors understand and research has confirmed, is seldom a winning strategy. However, would I adjust my asset allocation somewhat, depending upon where I thought we were in the current economic cycle? 6+ years into the current economic recovery, I might consider dialing back my equity exposure 5-10% and raising a bit more cash as the opportunity cost does not appear to be too high. Problem is that, for many investors, its an all in or out mentality and their timing is terrible. I recall distinctly a day in late 1999 when I overheard a young couple in line at the coffee shop say: “…if we leave our money in the stock market for just 6 more months, we’ll have enough money to buy a house.” I suspect this strategy may not have ended well and has underscored for me the necessity of paying attention to what is going on around us and to remain well diversified, but flexible, in our asset allocation.

    • Ben commented on Mar 27

      I think you misunderstood the point of this post. I’m saying if you’re a buy and hold investor and you’re dollar cost averaging into the market over time (as the majority of people do) that you have to continue to make your periodic purchases when markets crash. And you can’t give up on this strategy and sell everything when markets rise.

  4. PanamanianStrongman commented on Mar 27

    Re: Both value and momentum have historically been shown to work well as stand-alone strategies.
    I’ve seen several academic studies that indicate value strategies work, but I’ve never seen any such studies for momentum strategies. If you have any citations, that would be appreciated.