On Investment Modeling, Part 3

This is the last piece intended in this series, but I know that I will get a some abuse for it.  One small request to those who agree with me on this issue: if I get flames as a result of this piece, and you disagree with the flames, please comment in my favor.  Thanks.


Warren Buffett once wrote a piece that is in one the editions of Ben Graham’s The Intelligent Investor, called The Superinvestors of Graham-and-Doddsville.  Buffett chooses nine investors that learned from Ben Graham, including himself, and shows how they outperformed the market averages over many years.

Very nice.  Another win for value investing.  I live in Graham-and-Doddsville for the most part, and have admiration for my neighbors.  No envy here.  I do well enough.

But, even though Buffett knew these investors long ago, and they were all students of Ben Graham, what I don’t know is whether Buffett culled only the best of Graham’s students for his essay.  I think the best of Buffett; I generally think he is an honest guy, but I don’t know for sure.  I write this as a convinced value investor.


Far better to try to do a general study.  The trouble is that it is difficult to segment the market into value investors, and everyone else.  The category is squishy.  Even if we could define the category well, we would have a hard time aggregating all of the data from all of the brokerage accounts.


So, what are we left with?  We boil down strategies into their quantitative essences, and measure the performance of the quantitative strategy versus the index.  The result is bloodless, and accurate to the first degree, in analyzing an investment strategy.

This is what the academics do.  Though I disagree with the Carhart factors, because I view them as alphas and not as betas, the basic idea of testing a strategy over the whole of the market is valid, if they take into account a full accounting for transaction costs.

See if the strategy is valid from the first approximation of turning it into a mathematical formula.  For value investing, it has worked.  Value factors have outperformed.  I love being a value investor, and I have been better than most of my competitors.

But that is not enough.  Price momentum factors have also outperformed.  Which brings me to my final point: Michael Covel hand-picked many successful trend followers in the his book, Trend Following.  He had more freedom to pick trend investors than Buffett did to pick value investors.  I give Michael Covel a choice:

  • Are you willing to recognize that value investing works, even as momentum investing works?
  • Or, do you end up a narrow-minded man who only sees one way to make  money in the markets?

Though I am mainly a value investor, I do not abhor momentum investing.  I incorporate it where I can.

But when Michael Covel chose other trend followers to demonstrate the value of his theory, he was less restrictive than Buffett was, and Buffett’s method was less than scientific.

I am not trying to pick a fight with Michael Covel.  On October 1st, we had a “discussion” over Twitter that he started, and I finished, where we discussed this topic.  Anyone who can re-assemble the full details of the topic please e-mail me, and I will post it.

I tried to be a gentleman, but Covel interpreted me as being a wimp.  I hate that.  A gentle answer discourages wrath, and that is what I aimed for, but he did not perceive it.


Much as I am not crazy about academics in finance, the way that they analyze strategies is the only fair way of analysis, because it allows for no discretion.

There are two choices for doing an economic analysis in finance:

  • Segment investors, and analyze their performance
  • Describe the distinct strategies of investors in easy quantitative terms, and show how they perform versus the index.

There are a large number of studies that show that price momentum is a winning strategy.  I agree with those, and let Michael Covel agree with me.  I am not looking for a debate, but an agreement.

With that, I leave it in the hands of my readers.  Why not incorporate both value and momentum into your investing?


Update: here is a transcript of the discussion with @Covel:

Covel: @AlephBlog You get grief because you don’t understand the subject and ignore the performance.

Merkel: @Covel As you wish sir.

Covel: @AlephBlog http://www.michaelcovel.com/2009/04/25/david-merkel-defending-a-wrong-view-to-the-bitter-end/

Merkel: @Covel I don’t bear grudges, do you?

Covel: @AlephBlog Is this seriously how you debate? Everything is an emotional counter?

Merkel: @Covel No, I still stand by what I wrote.  There are five parts, and you would do well to read them carefully.  My opinion is expressed.

Covel: @AlephBlog If you were serious about the subject you would examine the blind spots in your argument. You don’t and wise people see why.

Merkel: @Covel I responded in detail to your statements; you did not. Your use of “ad hominem” argumentation was without basis. Compare me w/Cramer?

Merkel: @Covel Look, I am fair. Please write a piece that shows pt-by-pt where I am wrong, or affirm that your last piece was that. I will +

Merkel: @Covel re-examine my “prejudices” and write a follow-up.  But, are you willing to be as fair? It’s your ball, run with it.

Covel: @AlephBlog If you are truly intellectually curious write a cogent argument for trend following performance. Don’t be lazy like your review.

Merkel: @Covel I have written many times on the value of using price momentum in investing.  I mentioned that in my reviews a number of times.

Merkel: @Covel Try this, then: http://alephblog.com/2009/01/21/a-different-look-at-industry-momentum/

Covel: @AlephBlog No banana. Explain the decades of trend following performance generated by the traders mentioned in my book. Let’s see it.

Merkel: @Covel In any strategy, those who do the best survive and get known. Using hindsight, they get picked to show that the strategy works.

Merkel: @Covel Buffett used the same argument for value investing in his essay The Superinvestors of Graham and Doddsville http://bit.ly/9IKsDf

Merkel: @Covel My answer to you is that cherry-picking is not analysis. Please do a study of all trend followers to prove your argument.

Merkel: @Covel Comprehensive article on the value of momentum and mean-reversion. http://bit.ly/cCzx2p This is what I think is careful research.

Covel: @AlephBlog Who are failures? Name them. Describe why they failed. Let’s see it. Don’t hide behind “Covel it’s only survivors!”

@edwardrooster @alephblog His argument is idiotic. He is trying to say thousands of trades over decades is luck. That is foolish.

Merkel: @Covel Selection of high performing investors does not prove that a method works. I am not saying anyone’s performance is luck. Momo works.

Covel: @AlephBlog I am out. Even if you read my book, there is no comprehension. Typical bias. Wrong, but unable to accept. You must protect self.

Merkel: @Covel Happy trails. Come back when you want to talk reasonably.  If you get to Baltimore, lunch is on me.