When new investors are just starting out in the markets they’re often told that a paper portfolio is a good way to test out a strategy without putting real money to work. This one sounds good in theory but is fairly useless in practice.
The thing is that there are no simulations that can prepare you for the emotions you feel when investing actual money in the markets. The feelings you get from making or losing money can’t be simulated. The same is true of those who try to turn research into an investable strategy.
His is book, Efficiently Inefficient, Lasse Pedersen posed a question to AQR’s Cliff Asness about the difference between investing in the real world and doing research in academia (emphasis mine):
Well the single biggest difference between the real world and academia is — this sounds overly scientific — time dilation. I’ll explain what I mean. This is not relativistic time dilation as the only time I move at speeds near light is when there is pizza involved. But to borrow the term, your sense of time does change when you are running real money. Suppose you look at a cumulative return of a strategy with a Sharpe ration of 0.7 and see a three year period with poor performance. It does not phase you one drop. You go: “Oh, look, that happened in 1973, but it came back by 1976, and that’s what a 0.7 Sharpe ratio does.” But living through those periods takes — subjectively, and in wear and tear on your internal organs — many times the actual time it really lasts. If you have a three year period where something doesn’t work, it ages you a decade. You face an immense pressure to change your models, you have bosses and clients who lose faith, and I cannot explain the amount of discipline you need.
I don’t think Asness is saying academic ideas can’t translate into legitimate strategies (they can). Or that academics can’t be successful in the markets (they can). It’s that there is an enormous difference between performing research on the markets and the implemenation of an actual strategy.
I’ve witnessed many seasoned investors over the years who have developed a well-thoughtout system or process decide to change it on the fly once they see something in real-time that didn’t occur during the historical sample set. “I won’t be surprised by that one next time,” they say. But there are always surprises, so form-fitting your strategy to every single type of environment or scenario is impossible.
It’s easier to make changes because it gives you an illusion of control that you’re actually doing something, even when no changes are necessary. Backtested strategies assume you follow the rules to the letter every single time. Backtests have discipline that most investors don’t have.
And as Asness alluded to, investing money on behalf of someone else adds yet another element to the equation. While individuals have no problem making mistakes with their own money, there is a whole different set of issues and emotions involved when investing client assets. There’s an additional layer of pressure that comes from being responsible for other people’s money. It takes an entirely different set of skills beyond portfolio management.
Not only do you have to make intelligent investment decisions, but you also have to market and sell your strategy, set realistic expectations and have the ability to effectively communicate when things go wrong. When others begin to doubt your strategy it becomes very easy for self-doubt to creep in as the herd mentality plays tricks on your thought process.
Every investor will have to deal with the following internal struggle many times throughout their investing lifetime: Is this an inevitably period of poor performance that comes along once every cycle or has the competitive advantage of my strategy been completely eroded?
It’s not just discipline and patience that are required. You also have to be able to understand why something is not working right now and understand why it should continue to work in the future. It takes a heavy dose of intellectual honesty to know the difference between being too stubborn to admit when you’re wrong and continuing to follow a legitimate, disciplined process that isn’t currently working.
From Great to Good