Monday, March 27, 2017

What kind of model to choose?

"For people who like that kind of thing, that is the kind of thing they like" 
"History does not repeat itself. The historians repeat one another."
- Max Beerbohm

Approaches to modeling go through fads and fashions. What was learned yesterday by MBA's will be the model of choice tomorrow. Certain approaches are employed because that is the approach the modeler wants or likes. The same applies to strategies. A value investor will not likely to turn into a growth investor. He likes that sort of thing. A quant will not become a discretionary storyteller. He likes the precision of the model.

If you believe the world can be described by factors, those are the type of models you will use. If you believe in trend-following, then that is the approach that will be employed in your portfolio. Sometimes an approach will be used regardless of its efficacy with actual performance results. Damn the data, I like the elegance of my model. If one specification does not work, another will be tried in an effort to find the right factors without looking at alternative approaches. For example, if some modelers use a Fama-French three factor model, then others will repeat that approach. Everyone will start to use the Fama-French approach as a baseline. There is nothing wrong with this in concept, but it can be taken to extremes.

We are not arguing that that there is anything inherently wrong with being a specific model follower or being biased with a specific framework. We are not arguing for an atheoretical approach. However, focus on one approach can create a myopic view of the world at the expense of performance. The simple question should always be, does the model work? Whether trend-following versus factor modeling, systematic or discretionary, longer-term versus short-term, the question is not acceptance by peers of the approach employed but whether it generate the results expected.  

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