by Ben Carlson, A Wealth of Common Sense
One of the most difficult aspects of investing is that to create a successful investment process you have to get used to the fact that youâre bound to have competing ideologies at times depending on where we are in the investment cycle.
Take buy and hold as an example. I like to say that any type of buy and hold strategy only works if youâre able to both buy and hold when markets crash.
And while it can be difficult to follow your plan during a market crash you have to have a completely different mindset during a bull market. To practice buy and hold (or some variation of it) you really have to be a practicing contrarian when stocks are going down and a practicing trend-follower when stocks are going up. You have to be willing to use two competing schools of thought at different times. Thatâs not always so easy to pull off.
In many ways this is similar to the two most well-known quantitative investing strategies â value and momentum. Each of these strategies seeks to take advantage of over- and under-reactions made in the market, but in very different ways. With a value strategy, stocks that have performed poorly for one reason or another become cheap as investors over-react by selling first and asking questions later. With a momentum strategy, stocks that have done well recently tend of continue doing well for short periods of time because investors initially under-react. Value and momentum each rely on mean reversion, but in different ways and over different time frames.
Both value and momentum have historically been shown to work well as stand-alone strategies. But these two contrasting ideas actually work very well when you pair them together because they can make up for each otherâs deficiencies during certain market environments. Therefore, diversifying these two return streams helps increase risk-adjusted returns.
But the implementation of a value/momentum combination will never work if the investor isnât willing to accept that there are two schools of thought that can complement one another. (Read more on the advantages of combining value and momentum from the team at Alpha Architect.)
Really this idea of dealing with competing ideologies will be true of any successful long-term investment strategy. At certain times you will have to be willing to take an uncomfortable stance. Sometimes that means going against the crowd. Other times itâs going to mean going along with the crowd.
You have to be intellectually honest with yourself to be able to pull this off.
Lately it seems that every investor would like to be considered a contrarian that goes against the herd. Itâs an intellectually stimulating position to be in. I think an actual contrarian strategy can be one in which an investor is willing to combine different approaches and consistently follow them throughout various points in the market cycle to manage risk and improve long-term performance.
Further Reading:
Avoiding the Extremes
Donât Take This Personally
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