The difficulty with testing and the mundane

In the words of P.J. O’Rourke, “Everybody wants to save the Earth; nobody wants to help mom do the dishes”. This is an excerpt from Guiseppe Paleologo's new book draft on portfolio management. Everyone wants to be the portfolio manager or the trader. Nobody wants to do the important work of backtesting and the careful analysis associated with building models correctly. Research takes time and is tedious. It is often boring, but the rewards are strong. For a large upfront investment, a good model will allow for significant time savings in the future and the ability to make consistent decisions. 

Sweat the details. There are no big issues to solve but the consistent work of building the models correctly.

Perfect information may not help you with investing

What if you had perfect information, could you make money? A new study suggests that even if you had the headlines of new announcements before the event, you would still have a problem. The study was quite simple. Assume you have perfect knowledge of some news, but you don't know what is the market reaction. Could you still make money? The answer is no. This has been tested in the paper, "When a crystal ball isn't enough to make you rich."

This study is based on the Nassim Taleb conjecture that if you gave an investor the next day's news 24 hours in advance, he would go bust in less than a year. Markets are complex. They will not behave as expected even when you know in advance what will happen in the news. For the study, the researchers found that of the 1500 participants of this game, half lost money and one in six went bust. Does this make any sense? They guessed the direction of stocks with a 51.5% accuracy and bonds with 56% accuracy. In general, the investors who played the game over-levered. They did not size their bets correctly by using some form of risk management. 

This is a variation of the efficient market hypothesis. On average, it is hard to make money in the markets even if you have clarity on the news. There will be some winners - investors who know how to size bets and be careful with their decisions. There will also be players who do not know how to size bets and make good decisions - they will go bust. What decision you make and how you make them matters. Knowing is one thing; doing is something else. 

Anxiety about downside risk not the same as uncertainty

Investor market behavior is often filled with anxiety - the negative emotion from the anticipation of future risk, specifically downside risk. Anxiety will be displayed with the behavior of investors through their exposure to negative news. "Anxiety is the response to future uncertainty about payoffs in a risky asset, resulting in strategic uncertainty driven by multiple narratives", see "Anxiety, Investment Behavior and Asset Market Volatility".

Anxiety focuses on downside risks and its increases in magnitude and can be measured through news stories and survey information. These measures of risk, a focus on the downside, are different from economic policy uncertainty or uncertainty indices in general which serve as proxies for subjective uncertainty and not downside risks. 

This research finds that there is a countercyclical relationship between anxiety and volatility. An increase in anxiety which driven by news of downside will be linked to lower volatility. Volatility and anxiety are not the same thing.