Book Review: What Works on Wall Street

This book was really popular in 1996, when it was published. James O’Shaughnessy gained access to the S&P Compustat database, and tested a wide variety of investment strategies to see which ones worked the best over a 43-year period. Unlike most books I will review at my site, this one does not get wholehearted approval from me. My background in econometrics makes me skeptical of some of the conclusions drawn by the book. There are several valuable things to learn from the book, which I will mention later; whether they justify purchase of the book is up to the reader.

My first problem is the title of the book. It should have been titled “What Has Worked on Wall Street.” Many analyses of history suffer from the time period analyzed. The author only had access to data from a fairly bullish period. Had he been able to analyze a full cycle that included the Great Depression, he might have come to different conclusions.

My second problem is that he tests a number of strategies that should yield similar results. One of them will end up the best — the one that happened to fit the curiosities of history that are unlikely to repeat. (That’s one reason why I use a blend of value metrics when I do stock selection. I can’t tell which one will work the best.) The one that works the best just happens to be the victor of a large data-mining exercise. Also, when you test so many strategies, and possibly some that did not make it into the book, the odds that the best strategy was best due to a fluke of history rises.
Now, what I liked about the book:

  1. Combining growth and value strategies produced the best risk-adjusted returns. The growth and value strategies that did the best embedded a little value inside growth, and a little growth inside value.
  2. Avoiding risk pays off in the long run, for the most part. If nothing else, one can maintain the strategy after bad years.
  3. Value and Momentum both work as strategies. They work best together.
  4. He did try to be statistically fair, avoiding look-ahead bias, diversifiying into 50 stocks, avoiding small stocks, and rebalancing annually.

Now, two mutual funds based on his “cornerstone growth” and “cornerstone value” strategies have run since the publication of the book. The value strategy has not worked, while the growth strategy has worked. Go figure, and it may reverse over the next ten years.

Now for those that like data-mining, and don’t want to pay anything, review Tweedy, Browne’s What Has Worked in Investing. This goes through the main factors that have worked also. Theirs are:

  1. Low P/B
  2. Low P/E
  3. Net Insider Buying
  4. Significant Declines in the Stock Price (anti-momentum)
  5. Small Market Capitalization

Either way, pay attention to value factors, and if you trade often, use momentum. If you don’t trade often, avoid momentum.