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Market Strategies - The Philosophy

When I decided to become a self directed investor, I thought I could perform as well as those who manage money for a living, in other words, the people I used to trust my money too.

I came to the conclusion that the only difference between them and me was knowledge. I determined that the way they started to gain that knowledge, was to go to school where a professor told them to read a book, and then they were tested on what they read.

I know how to read, so I started. I have many investment books back in my study and I've read them multiple times.

I studied various investment styles from momentum, to value, to contrarion, to speculation, to shorting, to trading. I've enjoyed "some" success in all of them. What I lacked was the experience to make a specific style successful in all market conditions. So I trekked on, learning and applying and learning some more.

This series of instablogs is about sharing some of those findings and those findings are credited to James O'Shaughnessy and his book, "What Works On Wall Street."

O'Shaughnessy back tested many various strategies over a 40 plus year period, through all types of market conditions. Some strategies worked better than others.

O'Shaughnessy showed that a portfolio's returns are essentially determined by the factors that define the portfolio. He found that most investment strategies are mediocre and that the majority, particularly those most appealing to investors over the short term, fail to beat the simple strategy of indexing to the S&P 500.

O'Shaughnessy found that you can do four times as well as the S&P 500 by concentrating on large, well-known stocks with high dividend yields.

I interpreted high dividend yields to be 50% or more above what the S&P 500 yield is. Other sources have defined and confirmed that for me.

O'Shaughnessy also found that a strategy's risk is one of the most important elements to consider. Thoughts like, "No risk, no gain," should be left to the rookies. The key to the most successful strategies, over the long term, were based on a more conservative approach, what we might define as risk adjusted.

Before delving into some of the components on what makes up a successful strategy, which I will cover in the next article, I think it is important to touch on the psychology of the market, or why an investment philosophy is so important, and that's the focus of this instablog.

David Faust, in his book "The Limits of Scientific Reasoning," found that human judges were consistently outperformed by simple actuarial models. Like money managers and retail investors, most professionals cannot beat the passive implementation of time-tested formulas.

Robyn Dawes, in his book, "House of Cards: Psychology and Psychotherapy Built On Myth," tells us there are instances where the human judges had more information than the model and were given the results of the quantitative models before being asked for a prediction. The human judges still failed to beat the actuarial models.

I think it's time to stop and think about those last two paragraphs!

Humans were told what the results are going to be and they still got it wrong. Why is that?

In a famous cartoon, Pogo says: "We've met the enemy, and he is us."

I am of the belief that most people who invest in a company are not the same people who manage that investment. Once we have committed to an investment, it appears we have made an emotional attachment. We defend that position even when it goes against us.

We do our best to sell ourselves that we're not emotionally attached, but we are. This is one of the reasons investment firms have "buy side" and "sell side" analysts, and have them situated in different locations. The firms understand, all to well, about emotional attachment. I've been there, I know. I still struggle with it at times.

Case in point: EXC was showing strong capital appreciation as share price rose all the way up to $90. They were growing the dividend as they went. Those who owned EXC through all of that were very comfortable with their position. They weren't mentally prepared for what happened next. After seeing share price continue lower and lower, EXC froze the dividend. Price dropped below $30. People justified holding on. I did too. Guilty as charged Your Honor!"

EXC was no longer the company I purchased, but I wasn't ready to let go. Capital gains started slipping away. Finally management announced they might have to cut the dividend in six months. They gave the answer to the test, and people still got it wrong. EXC has finally made it official. The dividend will be cut and people still think it's okay to hold on and try to ride it back up, provided it does. ... Why?

For those who bought EXC a few years ago, and are still holding on, it's not the same company anymore. At what point do you let go? The person who bought the company, the "buy side" of us, isn't the same person managing that position. Those people haven't developed a "sell side" criteria.

Why models beat humans ---

O'Shaughnessy found that models beat human forecasters because they reliably and consistently apply the same criteria time after time after time. In almost every instance, it is the total reliability of application of the model that accounts for its superior performance. Models never vary. They are always consistent. They are never moody. They never get bored. They don't favor vivid, interesting stories. They don't take things personally. They don't have ego's and they aren't out to prove anything.

Our decision making is systematically flawed because we prefer gut reactions and individual, colorful stories to boring entry and exit base rates.

We prefer the complex and artificial to the simple an unadorned. This is why so many people are under weighted utilities, especially since highly rated utilities have shown to be one of the best long term strategies in the market. It's too easy. It's too simple. It's not sophisticated enough.

We are certain that investment success requires an incredibly complex ability to judge a host of variables correctly and then act upon that knowledge. We try to be "too smart."

O'Shaughnessy has found several strategies that work well over the long run, some better than others, but not enough to alter your strategy if the strategy you use matches up with his research.

Regardless of which strategy you choose to use, the two most important components are discipline and consistency. A structured approach has been found to be the most effective. If a stock meets the criteria, it's bought. If not, not. No hunches or intuition. No guessing or speculating.

Think of a pilot going down his checklist before takeoff. Everything must check out or they don't take off. Perhaps we should have a checklist just as that pilot does, and we need to insure that each of the criteria is met before buying. Then develop a checklist for the "sell side."

In O'Shaughnessy's book, "Invest Like The Best," he found the one thing uniting the best managers was their consistency to their rules. John Neff of the Windsor Fund and Peter Lynch of Magellan were known for their devotion to their investment strategies.

As I continue with this series on the psychology of the market, it is my hope that we learn the best strategies to use and then let them work. Don't try to outsmart them, don't abandon them if they are going through a rough patch. Understand the nature of what you are using and let it work.

In the words of Johann Wolfgang Von Goethe ---

--- To think is easy. To act is difficult. To act as one thinks is the most difficult of all.