Time and again investment decisions are made based on past performance, often with less than desirable results. Nick Dewhirst explains why he is a dedicated follower of the unfashionable
When rocket scientists blame the poor performance of computer models in practice on unprecedented events, there must be a lesson worth learning. Time and again I have felt mentally sub-normal when faced with their intellectual credentials, yet time and again they make the same excuse.
When they say, "we are seeing things that were 25-standard deviation events, several days in a row", gullibility is surely stretched to breaking point, because that is equivalent to the odds of a meteorite striking the earth not just for the first time in 100,000 years but every day for the next week.
This is a subject about which I have gained some understanding from personal experience on four occasions, reading a couple of good books and by building my own models.
Regarding my own experience, as a novice institutional salesman, when times were tough in 1974, I persuaded my clients about the merits of switch charts. Instead of sitting out the worst bear market in British history, the idea was to minimise the losses or maximise the gains, whichever way the market went, by switching between pairs of large liquid shares that had fluctuated within a stable range as far back as I could manually calculate them. That went fine between Shell and Royal Dutch and between Unilever Ltd and Unilever NV, but sadly wrong between BP and Burmah Oil, when the latter went bust the week that the bear market hit bottom. Then I was well-meaning but naive and hedge funds had not been invented.
The second time I was fresh off the boat in Germany with a licence to sell US securities in Duesseldorf, where the top-performing salesman was a local academic who had written the first book in German on the new options market in Chicago. Instead of holding a portfolio of shares, his thesis was that one could maximise returns and minimise risk by keeping 90% in Treasury Bills and investing 10% in call options. Sadly his clients often lost the first 10%, then more 10% slices, and threw in their hand before the market finally rallied. Then I was an overawed observer and losing money that way was unprecedented.
The third time was in 1980, when the media promoted the Death of Equities and head office promoted alternative investments, specifically the firm's Guided Commodity Fund. The idea was that computers would analyse past performance of commodity prices to generate buy and sell signals on the basis of which futures portfolios would be managed on a discretionary basis. Back-testing during the volatile markets of the last commodities boom promised spectacular returns with risk reduced by diversification. Sadly volatility was short-lived when inflation was brought under control. Then I was a selfish salesman, luckily reluctant to hand over control of his client's assets.
The fourth time was in 1987 when I worked at an institutional equities boutique which had its own fund management affiliate. Head office wanted us to introduce its portfolio insurance specialist to our clients. The idea was that fund managers could insure against losses (and thus afford to invest more) by authorising our firm to hedge their portfolios. This would be cheap because they would not be using expensive put options but instead sell futures contracts only when markets fell below a trigger point, which was set to exclude normal market movements but only be activated if a significant correction developed. Sadly the trigger was set at a 3% fall, but the next trade was 17% lower the same day because it turned out that too many other investors were playing the same game. Then I had learnt to be cynical enough to damn the promotion to my clients with faint praise.
As to the books, I recommend reading Adam Smith's The Money Game and Roger Lowenstein's When Genius Failed. It has all been seen before. The rocket scientists make the same mistake time and again, namely unrealistic assumptions about actual trading prices based on a past that excludes them, but a future that includes them, and probably others playing the same investment fashion. Therefore the reason that my own dumb but large system works, is that it has yet to become fashionable. n
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