Investing is a wonderful pursuit that can be tackled as an extension of a liberal arts education or from a more pure scientific approach. Either way, the pursuit is about finding mispricings in the market that can be exploited. That can be done as a value investor utilizing fundamental analysis to the creation of quantitative models that follow Stephen Ross’s general arbitrage pricing theory (APT). The key to being successful with either approach is about making smart decisions and smart decisions are based on what information is relied upon. And the key to relied upon information is the quality of the information and if we can recall it in the first place. In a perfect scenario, a range of reliable information would coalesce from a mosaic of diverse sources to generate useful and ultimately actionable insights.
Consider someone who recognized the demand for smart phones, the speed of cellular bandwidth, and social media’s popularity as transforming the advertising model as a rationale to invest in Facebook. The challenge is that such insights require some effort on our part to obtain quality information. Remember we are only offered information and we have to decide on the quality and reliability of that information. In a world now dominated by a continuous news cycle and a social media engineered web experience, it is more important than ever to examine what information we are consuming. The medium is the message, as Marshall McLuhan is famous for saying. The medium we source our information influences how we interpret the content in the medium. In a world of ‘likes’, 140 character tweets, inspirational gurus, and a 24/7 news cycle, Socrates’ examined life remains as an important endeavor as ever.
The best way to examine is to ask questions. Why is this important? What information is being presented to me? What biases am I liable for making a misjudgment? For example how we handle new information that doesn’t conform to our existing beliefs, which are based on past information that we hold to be true. Or maybe we are listening to a particular guru and taking their words at face value. For example blindly investing based on the holdings disclosed by famous investors (i.e. their periodic 13-F filings) or dismissing Facebook as an investment based on the failures of MySpace or Geocities.
We can see that in the academic world of portfolio construction. Consider the debate on what asset pricing model to use to construct a portfolio. First was the single factor model, the CAPM or Capital Asset Pricing Model, developed in the 1960s. This model stated that the return was related to the relative exposure, defined as beta, of the market. Any return by a portfolio above the market and unexplained by beta was called alpha. Ross expanded it to a generic model (i.e. APT). Over the years the 1 factor beta model has expanded to dozens of factors. Today, Vanguard references the 5 factor model proposed by Fama and French. Here’s the abstract of the referenced research note by Fama and French titled «Choosing Factors»:
We examine three issues about choice of factors in the five-factor model of Fama and French (FF 2015): (i) cash profitability (CP) versus operating profitability (OP) as the variable used to construct profitability factors, (ii) long – short spread factors versus excess returns on the long or short ends of the spread factors, and (iii) factors that use the small or big ends of value, profitability, and investment factors versus averages of small and big components. We rank models primarily on the max squared Sharpe ratio for model factors, Sh2(f). This metric leads to a three-way tie for best model honors. We choose among them using other common performance metrics. The ultimate winner is the spread factor model of FF (2015) with the OP profitability factor replaced by a CP factor. Researchers
Seems the debate continues some 50 years after the first market pricing model was developed and over 80 years since the first edition of Security Analysis was published by Graham and Dodd. The game of arbitrage continues. However, consider the longevity of the wisdom behind investing based on Benjamin Graham’s value principles versus factor investing. Fundamental analysis today remains as valid as it did 100 years ago while factor investing is ultimately arbitrage based on statistics and finding anomalies that might or might not persist. Consider the disappearance at times of both the small cap and value premiums. While I am a proponent of factor investing, it is a good reminder that what information we choose to use has a shelf life and must be reexamined from time to time. The longer the shelf life the easier it is to compound with other knowledge to generate those useful insights needed for successful investing.
Which leads me to the last point. Don’t forget that we forget. There’s even a curve, appropriately named the forgetting curve, to remind us. Back in the 19th century a German philosopher, Hermann Ebbinghaus, plotted a curve to show based on level of reinforcement how fast we forgot. Turns out that Ebbinghaus recommended mnemonics and periodic recall as ways to strengthen our memory and slow the decay of memory loss. Those Greeks were on to something because not long before Socrates argued the value of an examined life, Simonides a Greek poet shared how he used physical loci to help remember information. We now call that technique creating a memory palace. The reality is that even if we only remembered the big ideas from the various disciplines we still need some method to remember all of the various models. A popular blog Farnam Street lists over 100 models that can be used to create that rich mosaic of sources for truly unique and useful insights..
The conclusion is that investing can be both art and science and either way, the key is successful management and retention of useful information. The more useful information from diverse sources, the great insights that can be had relative to other investors. The challenge is that those insights require diligence when information is often presented in a medium designed to influence rather than inform. Furthermore even quality information can exhibit a shelf life and may need to be reexamined from time to time. The more one can build a mental database with existing quality information and utilize it, the odds can only improve in finding that mispricing that everyone else has overlooked.