The Aleph Blog » Blog Archive » The Rules, Part LI

The Rules, Part LI

65% of the time, the rules work.  30% of the time, the rules don’t work. 5% of the time, the opposite of the rules works.

When I wrote that to Cramer in 2003, his comment was that he loved it.  To me, this meta-rule about market rules in general expresses how markets work.  Re-expressing the three periods:

1) There are rules, and they work most of the time.  Value and Momentum strategies work on average.  So do many other strategies that work off accounting quality, distress, neglect, company quality, low volatility, etc.

2) But they don’t work all of the time.  Sometimes it seems that there is no discernible reward to a strategy, and performance is market-like.

3) But even valid strategies occasionally attract too many followers.  Too many foxes versus rabbits, means that foxes will die.  During those times, you think that the world is coming to an end, but these times are usually mercifully short.

In early 2000, a lot of great value investors got fired.  They had just suffered the worst period of relative performance in a decade, and investors were fed up.  Those firings were a sign that things were about to improve for value investing.  Near market troughs, qualitative signals occur to show that people are giving up because the rules have been reversed.

What does this mean for us regarding portfolio management?  The first and easiest solution is to stick to your discipline no matter what, and ride out the hard times.  After all, the rules work most of the time; you will get rewarded following them.

It is like what Max Heine said to Michael Price during Price’s younger days (extreme paraphrase from memory): If you follow this method, you will earn 15% per year on average.  One year out of ten, you will look like a genius.  One year out of ten, you will look like a loser.  Be mentally prepared for that.

And perhaps, that is the main message here.  Be prepared, like a good Boy Scout.  Be prepared for the days when your strategies, so strong in the past, go dead, or even become corrosive.  That is not a reason to abandon strategies that have a strong argument behind them, like momentum, value, etc.  It is a time to show courage, and buy the best stocks you can find.  Crises test investors, and the best stick to their guns and concentrate on the best opportunities.

The irregularity of the markets exists to shake out market players that cannot handle losses.  Those that cannot handle losses had unrealistic expectations.  Markets are perverse, and they suck in amateurs near peaks, and the amateurs leave near troughs.  They help provide the excess performance of the best.

The second message is to realize there are no strategies that work year-after-year, and that you have to accept years where your normally valid strategies  don’t work, or worse, become toxic. Don’t lose heart.

The third message is after a strategy has had a long run of success, don’t be afraid to lighten up.   Eventually the evil days come, when the results of investing at high prices relative to value are punished.

Follow the rules, then, and be ready to absorb losses during the fleeting bad times.






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3 Responses to The Rules, Part LI

  1. [...] David Merkel, “The irregularity of the markets exists to shake out market players that cannot handle losses.  Those that cannot handle losses had unrealistic expectations.  Markets are perverse, and they suck in amateurs near peaks, and the amateurs leave near troughs.  They help provide the excess performance of the best.”  (Aleph Blog) [...]

  2. bbarberayr says:

    The other approach is to try and identify the cycle and adjust your investments accordingly.

    At a high-level:

    1. Early cycle -> deep value stocks
    2. Mid-cycle ->stocks that grow with the economy at a fair valuation
    3. Late cycle -> value protection stocks

    Seems like we are early in the mid-cycle type market in the US now (because it is hard to find deep value), but still in the early cycle in Europe and possibly the emerging markets.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


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