Saturday, February 22, 2020

Mean reversion in style factors - Don't go chasing returns

"Don't chase those returns." "Follow what is best." There is aways contradictory advice with investments because returns are time varying and usually mean-revert. This applies to style factors as well as traditional betas. 

A simple analysis from MFS analyst Noah Rumpf in his study "Value, Momentum and Mean Reversion in Factor Returns" provides some useful insights on mean-reversion and style factors. Using the Fama-French database of 13 different style factors, Rumpf finds strong mean reversion. He uses a  simple sort of choosing the best factors and then looks at the forward performance.

If you pick a portfolio of the best four factor returns over the last 10-years, it will be the worst performing portfolio over the next year. The worst four factors will outperform the best over the next year. The classic idea of tracking returns and finding the best past performance will only result in financial heartache. Choosing the worst will have a better chance for success. 

The simplest solution to the mean reversion problem is to choose a diversified portfolio of good and bad factors. The bad ones are likely to be the least correlated with the good factors. Think about the environment and not the past performance. 

Friday, February 21, 2020

Primacy and recency effects - The ordering of ideas matters

If I give you a list of five important investment ideas, you will likely remember the first and the last, and forget the ideas in the middle. Exploiting the primacy and recency effect is used with almost all marketing and screen development. What we look at first and last matters.  

This knowledge can be used with investment decision-making especially given there is so much data to review in any given day. This seems obvious, but the critical issue is to ensure recall. The development of investment dashboards has grown as managers have tried to condense information on a screen. The primacy effect says to focus on what is most important to the top of the dashboard. Similarly, recency tells us to also place important information at the end of a report. 

Similarly, all marketing and research material should exploit these recall effects. What is said in the middle does not matter because the audience will not remember your point. Obviously, we have always had a bias to quantitative modeling because there will be no primacy and recency effects, but at some point even output will have to be reviewed, so ordering output will matter.  

Thursday, February 20, 2020

Financial Repression - Still a growing issue around the world

It is critical to know the financial environment we are navigating. Currently, we are in a world of financial repression through policies that hurt savers, encourage speculation, and hampers growth. This has been going on for approximately a decade. It is strong language but it is an apt framework for thinking about investment decisions and portfolio construction. We have written on this theme in the past, but it critical to understand this regime.

Financial repression is the use of government regulatory or monetary policy to capture or under-pay domestic savers in an attempt to strengthen growth, meet policy objectives like cutting the cost of debt, or funneling funds to specific projects. The phrase by Ronald McKinnon was first used to describe the policy actions of emerging markets, but it now represents the objective of many advanced economies.
  • Maintain low rates and/or negative real rates to cut the cost of debt; the whole QE policy focus.
  • Use "macro-prudential" policies to limit growth and control banking, finance, and insurance industries.
  • Develop debtor friendly policies relative to creditors/savers to reduce the burden on borrowers.
  • Develop policies that limit flow or control capital to reduce the impact domestic debtors.

All of these policies may be classified as financial repression. Some may serve useful short-term goals, but they all serve as a form of hidden taxation on savers. Inflation, regulation, forced negative rates, and capital controls are saving taxes that attempt to repurpose capital. If temporary policies turn more permanent, there will be significant distortions as savers attempt to avoid the repression.

The response of markets is predictable. Savers engage in riskier investments to offset the repression, the search or reach for yield. The low real rates support marginal firms, industrial and financial zombies that should not exist. Those firms that can borrow will borrow and allow for equity buy-backs over demand driven investments. Unfortunately, these repression regimes can last for decades because the reversals of economic distortions are  painful. 

A transition away from financial repression is not a burst of financial freedom that will be good for markets but a potentially violent upheaval as market adjust to "normalcy". Call it the big tail event, but financial repression is not easy to eradicate. Still, it is critical to think through a portfolio barbell of holding real assets and prepare for a tail contingency. 

 See Financial Repression is Here - Helicopter Money and MMT Coming 

Tuesday, February 18, 2020

Instrumental and epistemic rationality - worth thinking deeper about decision behavior and intelligence

Rationality has been defined as either being instrumental and epistemic. See the work of Keith Stanovich, the cognitive scientist focused on the psychology of reasoning and others for more details. Given this construct, it is relevant to think about the different forms of rationality to help explain why investors make good and bad decisions. Investor may act rational in that they are trying to meet their goals. The problem is their belief system may be wrong. 

Rationality is not the same as intelligence, so someone who is intelligent may not always act rational. Similarly, if there is a range of intelligence, we should also expect a range of rationality.  It is not just a yes-no issue.

Instrumental rationality, according to Stanovich, means behaving in the world so that you get exactly what you most want, given the resources (physical and mental) available to you. You are and act like an optimizer for your goals. 

However, there is another form of rationality. Epistemic rationality is concerned with how well beliefs map onto the actual structure of the world. This is often referred to as theoretical or evidential rationality. This is where there is more potential for irrationality. You are wrong or irrational because your beliefs do not match with reality. There is rationality in your implementation, but it can be based on wrong beliefs or belief updating. If you are epistemic rational, you will be skeptical of unfounded beliefs and change beliefs as new evidence is presented.

This combination is the rationality that we often talk about as economists in an expected utility framework. It is process driven can be described through the axioms of choice. If we follow those axioms, then we are behaving rationally. If we act to fulfill our goals, we are rational regardless of the view of others. Given the axioms of choice, it relatively easy to measure whether someone is acting rational or committing errors, just check for violations of consistency. However, these behavioral tests do not measure intelligence, and do not tell us much about rationality of the individual.

Rationality can be consistent with wrong beliefs. There can be optimization of beliefs that are wrong or have the wrong likelihoods. Someone can follow the axioms of choice but make bad decisions on beliefs. This closer breakdown of rationality does not dismiss biases and errors in decision-making. Rather, these differences in rationality require us to look deeper on why mistakes are made. 

There can be degrees of rationality like degrees of intelligence. You are on both an intelligence and rational spectrum. The rational person blends the reflective mind of beliefs and goals with algorithmic mind that processes information. To truly understand the behavioral finance revolution requires not just an understanding of decision errors but the forms of rationality and why they may change. Picking the right portfolio manager is looking at the blend of rationality and intelligence.