Research-driven strategies sound terrific, until you try applying them to the real world. Relying on such notions is a good way to lose money.
Sometimes even the best ideas are only good in theory because they are impossible to implement in practice. This holds true to the financial world as well. While academics and research firms generate hundreds of papers each year to try to get some insight on the direction of the stock market, those approaches are simply impracticable.
You probably remember this Aesop fable: Once upon a time, the mice called a meeting to determine a plan to protect themselves from a cat so that they would not continue to lose members of their clan. After much discussion, a young mouse devised a plan.
They would tie a bell around the cat’s neck, which would alert them when the cat was nearby, giving them enough time to escape. Many of the mice were excited about this great idea until one wise mouse asked: “Who will bell the cat?” It is one thing to say that something should be done, but quite a different matter to successfully execute it.
Or in the case of investing, it is one thing to pick out tactics that may work in a research lab, but quite another to implement them in the real world.
For decades, financial researchers explored dozens of quantitative indicators as well as various measures of investor sentiment in an effort to discover the ones with predictive value. Many use less than scientific standards such as the alignment of planets or weather to predict future stock movement. Even though some of the research is rigorous and may have validity, it is problematic when brought into the real world.
One approach that attracted considerable attention in recent years is adjusting investments based on the CAPE ratio – the cyclically adjusted price/earnings ratio. Academics Robert Schuller of Yale University and John Campbell of Harvard seeks to provide investors with a way to improve their portfolio performance by overweighting stocks during periods of low valuation and underweighting stocks during periods of high valuation. Seems simple enough, no?
Well, it turns out that the challenge of profiting from this approach and many other quantitative indicators is to design a trading rule to identify the correct time to underweight or overweight stocks.
Knowing if stocks are above or below the long-term average valuation is not enough. How far above valuation before investors should reduce equity exposure? And at what point will stocks be sufficiently attractive – below average – for repurchase? Average? Slightly above average? While sounding like a good idea, the ratio is unable to provide investors with additional insight.
A successful timing strategy is the fountain of youth of the investment world. It’s much harder to “bell the cat” in reality.
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