Introduction to Fact Based Investing
Fact Based Investing
Fact-Based Investing, concentrating on the ‘what is’ of Market supply and demand, rejects the ‘what might be’ of Prediction-Based Investing and the ‘what ought to be’ of Theory-Based Investing. By combining trend identification and high-performance portfolio selection, Fact-Based Investing strategy gives you what I believe to be the best chance of achieving twin goals: to prosper in Bull markets, and to be protected from Bear markets.
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“When the gates are all down and the signals are flashing
And the whistle is screaming in vain;
And you stay on the tracks, ignoring the facts,
Well, you can’t blame the wreck on the train!”
This great lyric, from a tune recorded by Don McLean called “You Can’t Blame the Train”, applies to investing just as much as it does to life in general!
Let's focus purely on FACTS, as they relate to personal investing. We’re going to look at an approach that's called ‘Fact-Based Investing’, and compare it to other approaches you may be familiar.
Lost at Sea
For a very long time, many investors have felt ‘lost at sea’ for protracted stretches in their investing lives.
The major averages went nowhere for more a decade, for example, from 2000-2009 … to say nothing of the two 50+% declines that happened along the way. And the fear that that stretch inflicted upon investors, has caused many of them to not fully participate in the vigorous run-ups in the Market. Many investors have felt that their investment portfolios were being tossed about by whatever storm passes through the Markets … in other words, adrift, with not enough progress - owing either to a too-great equities exposure during bad times, or to a too-meager equities exposure in good times.
Here’s a quote from Albert Einstein that is right on target. He said, "The definition of insanity is doing the same thing over and over again and expecting a different result." Many investors have certainly been doing the same things repeatedly, yet expecting a different result.
Predictions & Theories
The great majority of advice that investors have received for the last several decades, has been derived from two basic lines of thought.
- Predictions about what might occur. Predictions come in many forms like opinions, outlooks and forecasts. Predictions can be dangerous! Everywhere you turn, you can find predictions from books, magazines, newspapers, TV, websites, and blogs telling you - with great confidence - what the Market is going to do.
- Theories about what should occur, in the Markets. This category of advice can be labeled Theory-Based Investing. Academic theory states what ought to happen and how Markets and investors ought to behave, based on theoretical models and equations.
One of the most widely-followed academic theories is that diversification protects investors in declining Markets. The idea is that different types of investments will march to the beats of different drummers, and so - theoretically - while some asset classes are going down, others might be going up. " Prior to the 2007 crash, many of us thought that as long as our portfolios were diversified among several standard equity and fixed-income asset classes, a dip in one would be balanced out by another, and it wouldn't be too long before we'd be back on track in working toward our investment goals. Still, most of us lost big chunks of our nest eggs in the recent financial crisis. As the S&P 500 Index and core-type large-blend funds, on average, lost 55% between October 2007 and March 2009, every other major asset class, with the exception of government bonds, also swam in red ink. Thus, even "diversified" portfolios experienced major losses Nadia Papagiannis, CFA | 09-24-09."
Fact Based Investing
Here are three major characteristics of Fact-Based Investing: First, and most importantly, there are no predictions in Fact-Based Investing. We get our direction instead from ‘what is’, and not from the prediction-oriented ‘what might be.’ Second, Fact-Based Investing makes no assumptions about Market ‘efficiency’ or rationality. Fact-Based Investing embraces the reality of inefficient, irrational Markets, and tries to use those characteristics to our advantage. Third, Fact-Based Investing does not remain fully-invested regardless of Bear Market circumstances. The focus of Fact-Based Investing is entirely on careful measurements of ‘What Is’, rather than emphasizing the predictions of what ‘might’ happen tomorrow, or the theories of what ‘ought’ to happen tomorrow. We zero in on measurements that reflect the continuous tug-of-war between supply and demand. We believe that every single tick in the market - and every trend - results from imbalances in supply and demand. After all, if there were no imbalance of supply and demand, prices wouldn't budge at all. We believe longer-running trends are driven by longer-term imbalances in supply and demand.
From our supply and demand analysis, we arrive at two truths about the Market.
The first of these truths, derived from supply and demand, is that Markets trend, and frequently trend for years at a time. Trends can occur in any time frame, from intra-day to multi-decade.
The most useful trends for us are those that last from months to years at a time, commonly known as Bull Markets and Bear Markets. And the fact that Markets are irrational and prone to excesses can work to our advantage, because irrationality typically extends trends, both up and down. Our Fact-Based Investing methodology seeks to identify and capitalize on these kinds of Bull and Bear trends, in order to profit from, at times, an otherwise-unrewarding Market.
The second truth derived from supply and demand analysis applies to the selection of portfolio components. In Fact-Based Investing, the selection of portfolio-components is based upon the tendency of performance to persist. Researchers have labeled this phenomenon as ‘momentum’, and have documented its widespread existence in the Markets over a span of many decades. In his Second Law of Motion, Sir Isaac Newton said that a body in motion tends to stay in motion. Similarly, in the Stock Market, high performance has been shown to be more likely to continue than to reverse, at any given time. The same holds true for low performance. It, too, has been shown to be more likely to continue than to reverse, at any given time. Using continuous measurements of ‘what-is’, Fact-Based Investing simply selects high performers in portfolios, and excludes low performers. Fact-Based Investing makes no attempt to predict future changes or ‘the next big thing’ … instead, Fact-Based Investing relies on careful measurements of actual performance to guide portfolio construction.
Implementing a Fact-Based Strategy
The implementation of a Fact-Based Strategy requires just two kinds of tools:
- Tools to identify Bull and Bear trends; and
- Tools to identify high-performance portfolio candidates.
My goal is to be defensive and protected in Bear Markets, and to be fully-invested during Bull Markets.
The second tool of our Fact-Based Strategy seeks to identify high-performance portfolio candidates. Momentum, relative strength, rate-of-change, nearness-to-52-week-highs, and other measurements of performance characteristics, are all combined to produce rankings of portfolio candidates. High-performers are selected, low-performers are discarded, and the whole process is repeated at regular intervals, usually quarterly. This process of continuous self-renewal is intended to capture the benefits of long-term winners, without being dragged-down by the unnecessary inclusion of underperformers. Combining these two tools gives us a simple-yet-complete strategy, providing guidance on when to be defensive and when to be offensive and, when we are offensive, how to construct high-performance portfolios.
Summary
Fact-Based Investing, concentrating on the ‘what is’ of Market supply and demand, rejects the ‘what might be’ of Prediction-Based Investing and the ‘what ought to be’ of Theory-Based Investing. By combining trend identification and high-performance portfolio selection, our Fact-Based Investing strategy gives us what we believe to be the best chance of achieving our twin goals: to prosper in Bulls, and to be protected from Bears.