Even bad strategies will perform well
02 May, 2016
An abridged article by Corey Hoffstein, Newfound Research
Asset management can be a frustrating business. What is supposed to work in the long run can often go wildly against you in the short run. Worse: what is supposed to not work in the long run can go through periods of exceptional performance, adding insult to injury when you're underperforming.
Even deeply entrenched strategies, like "buy cheap and sell expensive" can go through periods like the dot-com bubble that can make the most devout follower question his religion.
We believe that knowing you will have to stomach short term volatility is a pre-requisite for achieving long term excess returns. Volatility in short term performance is necessary for the long run outperformance opportunity to exist.
Just as a strategy that seems sure to outperform in the long term (like buying cheap stocks) must sometimes underperform, a strategy that looks certain to fail in the long term (like buying expensive stocks) must sometimes outperform.
Our hypothesis is simple: if any investment approach is viewed as an easy way to outperform, then more investors will do it. More investors using the same approach means more capital will chase the same opportunities, which will drive up valuations. As valuations increase, future expected returns will decrease, causing the opportunity to disappear.
Outperformance is not about choosing the right strategy, like "buy cheap stocks". It is about having the discipline required to continue to follow the strategy in the face of short term underperformance. Many investors can buy cheap stocks, but it takes discipline to hold them long enough to enjoy the gains, especially when the cheap stocks are becoming cheaper in the short term.
For an investment approach to have long term expected outperformance, it has to be hard to stick with. The phrase, "if it were easy, everyone would do it" rings true.