The Cost of Long Term Outperformance - Short Term Pain

So you have found a great investment strategy or investment manager that you believe will provide you with a long term edge and better risk-adjusted returns than benchmark exposure – after fees, commissions, and taxes, of course. You’ve done your diligence, you are confident in the methods employed and you like the performance metrics. You know that nothing in investing is ever guaranteed, but you feel that this strategy will give you the best chance at long term success. You are ready to put some money to work.

So you sign up for that newsletter, fund your brokerage account and start following the trades. If its a money manager you will be working with, you sign the paperwork and you wire money into your new account.

You feel good about this – you are going to follow a disciplined process and you are ready to be a long term investor with a long term, persistent edge. You look forward to reaping the benefits of this decision over the next 3, 5, 10+ years.

Month one rolls by and your performance comes in -5.6% for the month.

“That ain’t hot. Well let’s see how the market did…S&P was -8.5%...ah, at least I did better than the market…that’s good.”

Fast forward a couple months and you have been working with the manager for a full calendar quarter now. The performance over this time period comes in at -2.5%.

“Down 2.5%. Not what I wanted, but its only the first quarter and the S&P 500 was down 5.5%, so at least I’m outperforming. But my advisor isn’t making me any money. Wait…am I paying this guy to lose me money? Well I guess it’s better than I could do on my own in an index fund. Stay the course.”

Fast forward a few more months and check again – the first six months of following the strategy and the strategy has recovered. It’s now +0.6% over this time period.

“Up 0.6%...looks like this is going to be a slow year. Boring. What’s the market doing? S&P 500 is -0.5% so far this year, so my advisor is doing a good job – at least he is outperforming the market by about 1%. But still, the outperformance doesn’t seem to be worth the fees I am paying. Let’s see how things go for a little longer.”

You close your computer and forget to check the markets for the next six months (LOL!). Six months later you remember that you have money with an advisor and decide to check how things are going. At this point you have invested with this guy for one full year and you expect to see some results – you are paying fees after all! You open your account and what do you see? One year performance, -14%.

“WTF? -14%? I thought this guy was supposed to be good? I thought he had a system? I thought this was supposed to work? Ugh. Well I pay this guy to help protect me from losses in addition to making me money, so maybe the market has been bad, lets see…S&P 500 one year returns…-8.1%. W.T.F. So I am paying this guy to manage my money, and over the last year he has not only managed to lose me money, but I would have been about 6% better off in a low cost index fund than by keeping my money with this guy. Screw this…I’m moving my money to Vanguard.”

Sound dramatic? It’s not – it’s actually commonplace. It’s the reason why a lot of hedge funds, which often cater to high net worth individuals and institutional investors (investors who are supposed to have a long term time frame and a level head when it comes to investing) often stipulate “lock up periods” when investors work with them.

But this isn’t just unique to high net worth individuals and institutions, it happens all the time with “retail traders” (mom and pop investors) and financial advisors too.

It’s called performance chasing. It is absolutely toxic to long term investment success. And it is the result of inadequate Emotional Capital.

What is Emotional Capital in this context? Emotional Capital is the reservoir of fortitude needed to withstand short term equity losses, short term underperformance versus a benchmark, or short term underperformance versus one’s peers when investing systematically. Emotional Capital is what is required in order to stick to a proven system when the results produced by that system are difficult to handle despite the fact that evidence points to the system’s long term viability.

Emotional Capital is not only required for successful investing with active algorithmic strategies, but for passive algorithmic strategies such as buy and hold as well. Did you or someone you know puke their positions in 2008/2009? How about during the dot-com bust in the early 2000’s? This was the result of either (a) lack of a plan or (b) lack of Emotional Capital.

So how do we bank the Emotional Capital needed to withstand the adversity that will surely show itself when engaging in systematic trading? Unlike financial capital, which can be earned or gifted, Emotional Capital can only be earned and the earning comes through study and understanding. Study and understanding of things like:

How would this strategy have handled past market regimes?

What were some of the worst periods for this strategy?

How often does this strategy go into a –X% drawdown?

What did past periods of underperformance relative to my benchmark look like?

Etc.

In short, Emotional Capital is earned by analyzing historically bad scenarios, accepting that things in the future can indeed be worse than they were in the past, and then sizing your exposure to a system accordingly based on an honest assessment of how much pain you can take when things get tough.

There are all sorts of ways to analyze a system, but one of my favorite things to do is to look at periods of historically bad performance, try to mentally put myself in the position of that period, and see how I feel. It’s masochistic, but it’s also necessary if you are going to succeed in this arena.

So with that in mind – let’s take a look at the Alpha Momentum Strategy and some of the periods of underperformance relative to a benchmark. For the purpose of this study, we will look at the time period from 1990 through 2017, and we will use the S&P 500 (not inclusive of dividends) as the benchmark.

The charts below show rolling performance of the Alpha Momentum Strategy vs the benchmark for 1, 6 and 12 month periods. When the data point is above the zero line, it means that the Alpha Momentum Strategy is outperforming the benchmark over the rolling time period (this means we are happy) and when the data point is below the zero line, it means that the benchmark is outperforming the Alpha Momentum Strategy (this is when the system becomes difficult to stick with).

We know that the strategy is robust and the testing results indicate a high probability of significantly outperforming the benchmark over a long time period, but the charts here show that the ride will not be easy!

As shown in the first chart, there will be a significant number of months where the strategy underperforms the benchmark, sometimes significantly!

In the 6 month and 12 month charts we see that, over longer time frames, the system shows its outperformance, but still there are significant windows of underperformance. There were even time frames in the early ‘90s where the system underperformed the index by almost 20% on a rolling 12 month basis – talk about a tough time to stick with the system!

Where am I going with all this? The bottom line is this:

Even with a solid strategy that has been shown to provide an edge resulting in long term, robust and significant outperformance, it isn’t necessarily going to be easy to follow that strategy. There will be times of relative underperformance, and times of loss.

An investor with Emotional Capital knows that the road will get difficult and that investor is thereby better prepared to handle that difficulty by way of his awareness.

There are no free lunches in this world, and the cost of long term outperformance in systematic trading is periods of short term pain. To manage that short term pain, cultivate Emotional Capital before employing a strategy – if you don’t, the short term pain just might be too great to bear, and failure to sustain through short term pain will guarantee the demise of your investment strategy.

More to come.