November 30, 2016

Mistakes of Momentum Investors

Like most investors, those using momentum are often guilty of chasing performance. In fact, momentum requires that we do this. But it should be done in a disciplined and systematic way. Performance chasing should not be due to myopia, irrational loss aversion, or other psychological biases.

Behavioral Challenges

It is not always easy adhering to a disciplined approach. If you are not vigilant, emotions can get the better of you. Even Daniel Kahneman, the father of behavioral economics, admits to being influenced by behavioral heuristics.

We may forget our strategy’s long-term expected outperformance when we experience uncomfortable drawdowns. The survival instinct kicks in strongly then. Recency bias can make us feel the drawdown will never end.

We may also have to deal with regret aversion when our portfolio underperforms. This will happen sooner or later. No strategy outperforms all the time. Occasional benchmark underperformance is the price we pay for possible protection from severe bear markets.


Those who look at performance frequently do not do as well as those who are less concerned with short-term performance. When someone asks me how my models are doing this year, I know they do not have a good understanding of momentum being a long-term approach.  Last May a dual momentum investor sent me an email saying his wife’s account in REITs was outperforming his momentum account. He then closed his account and invested in REITS himself. Since then, REITs have declined more than 10%, while momentum has gone up almost the same amount. This scenario has happened more frequently than you might think.

It is important to keep the big picture in mind. We should wait at least a full bull and bear market cycle before evaluating the performance of a dual momentum strategy. Do your homework so you understand whatever investment approach you select. Then relax, and enjoy the journey.

Accepting Lower Risk Premia

The other serious mistake momentum and other investors often make is not understanding the real goal of investing. We should invest in a way that offers us the highest expected return while limiting our risk exposure. Limiting downside exposure is important so we do not panic under stress and do stupid things.

The stock market has had two bear markets over the past 20 years in which stocks lost more than half their value. Because of this, investors have been extra cautious. Many have tried to use broad diversification to reduce their portfolios' drawdown exposure.

If you select non-correlated assets, you can achieve some reduction in volatility and drawdown. But your expected return is the weighted average return of all your assets. That is where the problem lies. Assets with lower expected returns will reduce your portfolio's return.
Bonds have done well over the past 15 years. But longer term, their real return is less than one-third the real return of stocks. Given how low interest rates are now, there is not much room for bonds to appreciate further. In fact, current interest rates predict low bond returns in the years ahead.

Bonds are also not as low-risk as you might think. Since 1900, the worst real return drawdown was 73% for stocks and 68% for bonds. As we see below, stocks and bonds can sometimes have severe drawdowns simultaneously.

Bonds can not only create a drag on our performance. They also may not reduce our risk exposure when we most need them to do so.

Some momentum investors still adhere to the old paradigm of extensive diversification. They hold more assets than they need to for optimal portfolio growth. Some use alternative assets like commodities because such assets are generally (but not always) less correlated to equities. They can therefore reduce portfolio volatility. But the addition of low-return alternative assets can create a serious drag on portfolio performance. Trend following absolute momentum lets us keep more of our assets in equities where we can receive more risk-premium.

Not Using Geographic Diversification

My first research paper released in 2011 analyzed equity momentum with individual stocks, sectors, style attributes, and regions. I showed that momentum works best when applied to geographically diversified equity indices. Last year Geczy and Samonov (2015) applied momentum to stocks, stock sectors, geographic equity indices, bonds, commodities, and currencies. They also found equity indices performed best. This is without considering the issues of scalability and trading costs associated with individual stocks.

Preference for Complexity

Investors and advisors seem to prefer complexity over simplicity. Many must believe that elaborate models and more diversified portfolios perform better than simpler approaches. Advisors may prefer complexity to justify their fees. It could be challenging to charge fees for putting clients in an S&P 500 index fund. Robo-advisors are the latest slice and dice diversification strategy for those who think more is better.

Non-Optimal Portfolio Construction
Some portfolios suffer because investors rely on well-known measures like the Sharpe ratio for selecting assets. The Sharpe ratio divides excess returns by the standard deviation of those returns. It is an efficiency measure telling you how much return you might expect per unit of volatility. But unless returns are normally distributed (they almost never are), the Sharpe ratio is not a good indicator of downside risk. Nor is it a good indicator of the amount of wealth you might accumulate or your chance of future investment success.[1]

Wiecki et al. (2016) looked at 818 algorithmic trading strategies at Quantopian, a research boutique. Using data from 2010 through 2015, they found that the Sharpe ratio offered little value in predicting out-of-sample performance.  This was also true of similar metrics such as the information ratio, Sortino ratio, and Calmar ratio.

You can increase the Sharpe ratio of most portfolios by simply adding more bonds. But your expected rate of return and accumulated wealth will in most cases suffer.

Here is an example showing the performance of the S&P 500 index compared to a balanced portfolio with 60% in the S&P 500 index and 40% in the Barclays Capital U.S. aggregate bond index. The data is from the start of the bond index in January 1976 until November 2016. It represents a possible 40 year holding period of someone saving for retirement.

S&P 500  60/40
CAGR  11.6%  10.4%
Standard Deviation  14.8%     9.6%
Sharpe Ratio   0.43   0.49
Worst Drawdown -50.9% -32.5%
$10,000 Grows to  $781,760 $507,070
Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.

The difference in annual return of 1.2% gives a 54% increase in ending wealth over this 40 year span. In this example, the most desirable portfolio may depend on your on your own risk tolerance. The 60/40 portfolio has a less painful worst drawdown.

Here are the results adding the simple Global Equities Momentum (GEM) model featured in my book and in an earlier blog post. GEM uses relative momentum to switch between U.S. and non-U.S. stock indices, and absolute momentum to switch into aggregate bonds when stocks are weak. GEM’s single parameter, the look back period, was discovered in 1937. GEM uses a combination of relative and absolute momentum. Both types of momentum have shown good results on over 200 years of back data.[2]

S&P 500   60/40   GEM
CAGR  11.6%  10.4%  17.1%
Standard Deviation  14.8%    9.6%   12.5%
Sharpe Ratio    0.43     0.49    0.87
Worst Drawdown -50.9% -32.5% -17.8%
$10,000 Grows to  $781,760 $507,070 $5,416,080
Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.

Which portfolio would you choose? How difficult would it be for you to live with GEM?

When I analyze investment opportunities, my primary criteria are a high CAGR combined with a tolerable level of risk exposure. CAGR represents the geometric growth rate of one’s capital.[3]  It takes volatility into account. If two strategies have the same average return, the one with lower volatility will have a higher CAGR.

But like the Sharpe ratio, CAGR does not measure tail risk. Extreme downside exposure can cause you to exit positions prematurely screaming in pain or cursing your investment advisor. That is why I also consider drawdowns.

Worst drawdown is only a single point in time, but it can give you a pretty good idea about tail risk. I also examine the distribution of returns and look at rolling windows of drawdowns. Keep in mind that your worst drawdown may lie ahead still. Having a simple, robust approach that performs well over a long period may reduce that risk.


It is important to remain focused on what is important – accumulating wealth while  protecting yourself from severe bear markets. Once you have a good investment strategy, you need to be patient so it can do its work for you. Warren Buffett said the stock market is a mechanism for transferring wealth from the impatient to the patient. This applies to momentum as well as to other investors.

[1] See Levy (2016).
[2]  See Geczy and Samonov (2015).
[3]  For econ geeks, CAGR is consistent with logarithmic utility. The Sharpe ratio represents quadratic utility, unless returns are normally distributed. See Friedman and Sandow (2004) and Levy (2016).

October 17, 2016

Book Review of Quantitative Momentum

I have been looking forward to Wes Gray and Jack Vogel's new book, Quantitative Momentum.

It is the only book besides my own Dual Momentum that relies on academic research to develop systematic momentum strategies. My book uses a macro approach of applying momentum to indices and asset classes. Wes and Jack (W&J) take the more common approach of applying momentum to individual stocks.

W&J begin their book with an excellent question. Since there is ample research showing momentum to be a superior investment approach over the past 200 years, why isn’t everyone using it?

W&J do a good job explaining the behavioral biases that keep many investors away from momentum. W&J also discuss marketplace constraints like advisor career risk when momentum underperforms its benchmark.

In Chapter 1 W&J give a short history of trend-based and fundamental analysis-based investing. They show that both approaches can work.

In Chapter 2 W&J discuss irrational traders who can dislocate prices from their fundamental values. In the case of value, investors overreact in the short-run to bad news. In the case of momentum, investors under react to good news.

Investment managers are hired to exploit long-run profit opportunities, but their performance is judged by investors looking at short-term results. Advisors who continue to focus on longer-term opportunities, like value or momentum, may get fired. This is one reason why anomalies like momentum do not get arbitraged away.

In one of the key points of the book, W&J discuss the importance of sustainable investors as well as sustainable alpha. Gregg Fisher once said, “We don’t have people with investment problems. We have investments with people problems.” Investors often lack the requisite patience to stay with their chosen strategies during inevitable periods of benchmark under performance.

To better prepare investors for challenging times ahead, W&J highlight the risks associated with value and momentum investing. They point to Julian Robertson’s Tiger Funds that lost almost all their clients by sticking to their value model in the late 1990s. Value underperformed the market in 5 out of 6 years, sometimes by double digits. W&J make this interesting statement, “True value investing is almost impossible.”

What can investors do about this? W&J point out that momentum is largely uncorrelated with value. This means an investment in momentum can make value investing more tolerable. But momentum and value are largely uncorrelated only when their market risk is hedged. Long-only momentum and value are correlated to the market and to each other. All three can simultaneously experience large bear market losses.

In Chapter 3 W&J give a brief history of momentum and the important psychological challenges facing momentum investors. W&J show that momentum, like value, can underperform over long periods. They point to a 5-year stretch when momentum underperformed the broad market by 15%. Staying the course during times like that can be a challenge for any investor.

In Chapter 4 W&J demonstrate that a 50/50 allocation to value and momentum can reduce the tracking error of separate value and momentum portfolios during extended periods of relative poor performance. What may also be worth noting is the decline over time of both value and momentum premia. Their chart below is consistent with Bhattacharya et al. (2012) and Hwang & Rubesam (2013) who find that stock momentum premium and profits have disappeared since the late 1990s. This underperformance of stock momentum is longer than can be expained by normal tracking error.

In Chapter 5 W&J show that frequently rebalanced, concentrated momentum portfolios perform best.


Stock momentum is a high turnover strategy, and many momentum stocks are volatile with wide bid-ask spreads. Therefore, there may be some price impact from trading in momentum stocks. This is especially true for frequently rebalanced, concentrated momentum portfolios.

W&J do say that concentrated portfolio/higher rebalance frequency is not a good approach for large asset managers with billions to invest because of scalability issues. But most investors draw upon the same universe of momentum stocks. Alpha Architect shows the top 100 momentum stocks on their website each month. All investors, not just multi-billion-dollar asset managers, may experience adverse price impact from trading the same momentum stocks as everyone else.

W&J point to a paper in the Journal of Financial Economics by Lesmond, Schill, and Zhou (2002) called "The Illusionary Nature of Momentum Profits." Lesmond et al. conclude that after transaction costs, momentum profits are largely illusionary. W&J also mention research by Korajczyk and Sadka (2004) showing that stock momentum has a limited capacity of only about $5 billion.

Offsetting these arguments, W&J present findings by Frazzini, Israel, and Moskowitz (2014) of AQR. Frazzini et al. argue that trading costs are manageable using optimized trading of proprietary data from 1998 through 2011 if one is willing to accept added tracking error. But the Frazzini et al. study applies to all stocks and not a focused portfolio of momentum stocks that are likely to have larger than average bid-ask spreads and be more subject to trade crowding.

Chapter 6 is where W&J explain path dependency and why it matters. They cite research by Da, Gurun, and Waracha (2014) showing that smooth and steady past performance is preferable to jumpy performance.

To implement this idea, W&J advocate double sorting stocks on both 12-2 month momentum and the percentage of positive daily returns over the past 252 trading days. What they call “high-quality momentum" are top decile momentum stocks with the largest percentage of positive daily returns. Results below are from 1927 through 2014. Transaction costs are not included.

The improvement in high-quality over generic momentum performance looks good. But a possible warning sign is W&J’s statement at the beginning of Chapter 6: “For over a year, we examined every respectable piece on momentum stock selection strategies we could find…”

Extensive data mining greatly increases the odds that favorable results may be due to chance. Say you have some studies each showing no significance with a 95% confidence level of being correct. If you examine 20 or more of these studies, there is a good chance that one of them will be look significant even though the chance of being correct is still only 5%. 
In Chapter 7 W&J attempt to further enhance momentum by adding seasonality. In the turn-of-the-year or January effect, investors engage in year-end tax loss selling. They hold on to their strongest stocks and may buy more as replacements for the stocks they sell. This can create abnormal profits in these stronger stocks.

Window dressing to make quarter-end portfolios look more attractive may also cause investment professionals to sell losers and buy winners before the end of the quarter. To take advantage of these seasonal tendencies, W&J advocate rebalancing their momentum portfolios at the end of February, May, August and November instead of each calendar quarter.

Here are the results from incorporating seasonality as “smart rebalancing.”

There is very little risk-adjusted improvement over agnostic (generic) momentum as you can see from the increase of only .01 in the Sharpe and Sortino ratios.  But since portfolios are rebalanced quarterly anyway, there should be no harm in picking non-calendar ending quarters to do it.

In Chapter 8 W&J suggest that readers address the trading cost issue by comparing the analysis presented in Lesmond et al. to Frazzini et al.

W&J then do an in-depth analysis of “quantitative momentum” with respect to reward, risk, and robustness. W&J say, “… strategies like value and momentum presumably will continue to work because they sometimes fail spectacularly relative to passive benchmarks.” This may not be great news for those who at that time hold momentum or value stocks. But W&J offer these words of  encouragement, “The ability to stay disciplined to a process is arguably the most important aspect of being a successful investor” (emphasis added).

In Chapter 9 W&J look at a recommended 50/50 allocation to an equal weight, quarterly rebalanced  momentum and value portfolio from 1974 through 2014.

The combined portfolio return is higher than momentum or value on their own. The combined portfolio has less tracking error vis-a-vis the broad market. Combining value and momentum also shortens both the length and depth of periods of benchmark under performance.

But volatility and drawdowns are still high. So as a final tweak to their approach, W&J apply a trend following overlay to the combined value and momentum portfolio. If a 12-month moving average of the S&P 500 index is greater than zero, they hold the combined portfolio. If the moving average is less than zero, they hold Treasury bills. Using this trend filter, the worst drawdown of the combined approach goes from -60.2% to -26.2%. But investors give up 1.5% in compound annual return, and there is an increase in tracking error.

My research shows that trend-following is more effective when applied to broad stock indices. The reason for this has to do with volatility. The standard deviation of W&J’s quantitative momentum and combined portfolios are 25.6% and 21.4%. The standard deviation of the S&P 500 index is 15.5%. Higher volatility means you give up more profit before you can exit or re-enter stocks when using a trend following filter. This is why combined stock portfolio investors give up 1.5% in annual return, while index momentum investors actually earn higher returns from adding a trend following filter.

W&J finish up by again mentioning relative performance risk. One cannot stress often enough the warning that myopic investors give up potentially superior results when they become nervous or impatient and abandon their strategies.

In an Appendix, W&J examine some possible enhancements to quantitative momentum. These include earnings momentum, proximity to 52-week highs, stop losses, and absolute strength. Although W&J use the terms interchangeably, you should not confuse absolute strength with absolute momentum. Otherwise, their analysis here is very good.

Overall, I recommend Quantitative Momentum for the following reasons:

1)    Its emphasis on the importance of sustainable investors who can keep the big picture in mind and not be swayed by short-term performance
2)    Its good review of momentum principles and behavioral biases
3)    Its rigorous research in the book’s Appendix

September 16, 2016

Factor Investing: Buyers Beware

A highlight of the 2016 Morningstar ETF Conference was the keynote address by the former leader of U.S. Navy Seal Team Six, Rob O’Neill. Chief O’Neill shared some stories about his training and operations as an elite Navy Seal. The take away lessons from his talk were the importance of preparation, discipline, and keeping the mission goal in mind.  Overriding all this is the importance of tenacity. A Navy Seal survives eight months of insanely intense training by advancing one hour at a time without ever giving up.

Another speaker at the event, Jason Hsu, showed that many professional investors do poorly because they lack this tenacity. They are instead influenced like the public by short term cyclical performance swings.. 

Investors often select investment managers or approaches based on 3 to 5 years of past performance. But 3 to 5 years is mean reverting with both markets and managers. Fired managers on average do 250 bps better than the new ones taking their place.  Most investors, both professional and public, tend to be market timers whether they know it or not. And they are poor ones at that. 

What we should do, according to Hsu, is stick with our long term goals and ignore shorter term cyclical performance swings.  In other words, investors would do well to follow Chief O’Neill’s advice – prepare well, and stick to your plan with discipline and determination.

To proceed with confidence, we need to have a good understanding of the investment factors we are using. There has been abundant academic research on factors, beginning in the early 1990s with size and value. Factors in general have shown favorable results on paper.  But now that factor-based investing has been around for a while, it might be useful to look at how factors have done on a real-time basis.

Out-of-Sample Factor Performance

McLean and Pontiff (2015) looked at 97 factors from academic literature that predicted cross-sectional stock returns. They found that factor returns were 58% lower following their publication. Calluzo, Moneta, and Topaloglu (2016) looked at 14 well-documented anomalies from 1982 through 2014. They included value, momentum, profitability, and investment. These authors found a 32% decay in average factor returns post-publication.

Glushkov (2015) examined a comprehensive sample of 164 domestic equities smart beta (SB) ETFs from 2003 through 2014. The factors examined were size, value, momentum, quality, beta, and volatility. Glushkov concluded, “I found no conclusive empirical evidence to support the hypothesis that SB ETFs outperformed their risk-adjusted benchmarks over the studied period.” 

Yet factor based investing has been growing in popularity. The emphasis of the Morningstar ETF Conference was factor investing, and Conference sponsors were busy promoting factor-based ETF products.

The Conference set the tone for this with an early talk by Ronen Israel of AQR that featured the two most popular factors, value and momentum. Israel pointed out momentum’s tax efficiency and how it can help offset value traps in a diversified value and momentum portfolio.

Momentum Issues

One of the issues associated with stock momentum is price impact due to scalability limits. Momentum performs substantially better with focused portfolios of 100 or fewer stocks and with frequent rebalancing. Unlike value, momentum is a high turnover strategy. If you turn over 30% of a 100 stock momentum portfolio each quarter, it does not take many billions of dollars to have a substantial impact on price.

Momentum stocks are also volatile with wide bid-ask spreads. This volatility contributes to their higher transaction costs. Israel pointed out a study by Lesmond et al (2004) in which transaction costs completely offset the profits of momentum investing. Israel then pointed to a proprietary 15-year data set showing momentum portfolios earning decent profits at the cost of more tracking error. A recent study by Fisher, Shah,and Titman (2015) using observed momentum stock bid-ask spreads found transaction costs to be higher than Israel’s figures and closer to Lesmond’s.

Momentum Performance

Let us take a look at the performance of two of the oldest momentum funds. They are the PowerShares DWA Momentum ETF (PDP) that began in March 2007 and the AQR U.S. Large Cap Momentum Style Fund (AMOMX) that started in July 2009. Both funds have underperformed their Morningstar designated benchmarks from their beginnings until now. This is too short a history to rely upon. But it is consistent with the study by Bhattacharya, Li, and Sonaer (2015) showing  insignificant stock momentum profits since 1999. Hwang and Rubesam (2013) show that the momentum premium of stocks disappeared in the early 1990s.

Annual Returns from Inception

PowerShares DWA Momentum    6.24
Russell 3000 Growth    8.11
Difference   -1.87

AQR Large Cap Momentum  14.24
Russell 1000 Growth 15.65
Difference  -1.41

Value Investing

Let us move on to value, which is the most popular investment factor. Of the 8000 or so U.S. mutual funds, more than 1000 are value funds. Value is the only factor that appears in every multi-factor ETF.

Israel showed that value is best determined using a combination of multiple valuation methods. All metrics performed about the same over the long run, but performance varies considerably over time. Of five different value metrics, earnings-to-price (E/P) was best overall, but it was the top metric in only 2 out of 6 decades.

The value premium has been insignificant among U.S. large cap stocks [1]. But Israel pointed out that value can still be useful when combined with momentum. According to Israel, value should make up one-third of a combined value and momentum portfolio, even if value has zero expected return. This is because value can reduce the volatility and tracking error of a momentum portfolio. But diversification this way can create considerable performance drag. In our Morningstar Conference breakout session on momentum, Wes Gray, Meb Faber, and I described how trend following could create a reduction in risk exposure without this kind of performance drag.

Value Performance

As we did with momentum, let us see now how value funds have performed real time. Using the CRSP database, Loughran and Houge (2006) looked at the performance of U.S. equity funds from 1962 through 2001. They used the prior 36 months to sort funds by style (top versus bottom quartile) and size (top versus bottom half). From 1965 through 2001, the average large cap growth fund returned 11.3% annually, while the average large cap value fund returned 11.41%. The outperformance of 0.11% for value over growth was insignificant.

For small caps, where value is said to have a greater advantage over growth, the authors’ results showed the opposite to be true. Small cap value funds earned 14.10%, while small cap growth funds returned 14.52%. Small cap value underperformed small cap growth by 0.42% per year. The authors say that bid-ask spreads, transaction costs, and the price impact of trading likely work against the capture of value premium in small-cap stocks. These are the same issues that concern us with respect to stock momentum. The authors conclude, “We propose that the value premium is simply beyond reach…investors should harbor no illusion that pursuit of a value style will generate superior long-run performance.” [2]
Source: Loghran and Houge (2006), “Do Investors Capture the Value Premium”

In addition, there can be horrendous tracking error associated with value investing. From January 1929 through June 1932, small cap value underperformed the market for 42 consecutive months. More recently, small cap value underperformed for 26 consecutive months from July 1989 through April 1981 and for 21 consecutive months from May 2014 through February 2016. I can't imagine many investors who would be willing to endure this.

Real World Versus Academic World

Most everyone likes the idea of value investing. We are used to finding bargains and buying what is cheap. But value stocks may look cheap for a reason. Serious tracking error and lower than expected real time returns are additional risk factors that make them less appealing. Perhaps Fama and French were on to something when they omitted momentum and made value redundant in their latest factor pricing model. 

The Capital Asset Pricing Model (CAPM), Mean-Variance Optimization (MVO), and Portfolio Insurance were all elegant academic concepts that looked great on paper, but never held up in the real world. Maybe factor-based stock investing will suffer the same fate. As Benoit Mandelbrot once said, "Many a grand theory has died under the onslaught of real data."

[1] See Asness et al.(2015).
[2] The median expense ratio for growth funds was 11 basis points higher than for value funds. Since growth funds also realized slightly higher average returns, expense ratios cannot explain the absence of a value premium across mutual fund styles.

August 29, 2016

Risk Tolerance Assessment

When I attended the Harvard Business School my favorite class was Managerial Economics.  It focused on decision making under uncertainty [1].

The first thing to understand here is the concept of expected value. You determine this by multiplying each outcome by the probability of its occurrence, then adding them all together. For example, the expected value of a coin flip where you win $10 with heads and lose $5 with tails is (.5 * $10) + (.5 *-$5) = $2.50. We should be indifferent between playing this game and receiving $2.50 without doing the coin flip. In this case, $2.50 is both the expected value and the “certainty equivalent,” or what we would accept for certain instead of playing the game.

Three elements affect how we play the coin flipping game:
  1. Risk aversion
  2. Risk capacity
  3. Risk tolerance

Risk Aversion

Let’s say we raise the stakes and with the same one-time coin flip we could win $10,000 with heads and lose $5000 with tails. Our expected value is $2500, but the amount we would accept for certain may now be different than $2500. Those who are risk seeking might play the game for an amount equal or greater to its expected value of $2500. Those who are risk averse would accept less than $2500 instead of playing the game. Someone conservative, who does not like the idea of losing $5000 on a coin flip, might pay something to not have to play.

Risk Capacity

The amount of risk aversion we have depends on the size of the outcome relative to our financial condition. Because of risk aversion, we buy insurance having a negative expected value (and a positive one for the insurance company) in order to avoid the risk of catastrophic loss. On the other hand, risk seekers may buy low-cost lottery tickets with extremely negative expected values for the small chance of an enormous payoff. This can be especially appealing to those having little to lose and much to gain.

Risk Tolerance

Risk tolerance defined by the ISO 22222 Personal Financial Planning Standards is “the extent to which a consumer is willing to risk experiencing a less favorable financial outcome in pursuit of a more favorable financial outcome.” It is an assessment of our psychological ability to deal with uncertain outcomes. It is not symmetric due to loss aversion. Investors will often trade $1.5 to $2 in gains to avoid $1 in losses [2].

Risk tolerance is generally a stable personality trait. But it is subject to situational influences, such as our mood, and may change due to our life experiences, such as aging.

Knowing our risk tolerance is important because financial decisions are motivated by emotional as well as logical factors. Investors, for example, often chase performance. They may invest based on attractive past results, then bail during periods of underperformance.

The 2016 annual Dalbar report showed the average U.S. equity fund investor earning 4.7% over the past 20 years, while the S&P 500 index gained 8.9%. Poor timing decisions caused nearly half of this underperformance. A dramatic case of this effect involved CGM Focus (CGMFX), the highest return U.S. stock fund from 2000 through 2010. It’s average annual return was 18.2%, but the fund’s typical shareholder lost 10% during that same period!  Investors added heavily to this volatile fund near the top and bailed out as the fund neared its bottom.

When markets go up we may hop on board without considering the volatility that lies ahead. Risk tolerance assessment can help us avoid this behavior by showing us ahead of time our psychological ability to deal with uncertainty and risk. This can help us choose more suitable investments.

Recognizing that we are sometimes more emotional than rational, FINRA issued Regulatory Notice 12-25 in July 2012. It added risk tolerance to the list of factors that should be used to determine investment suitability. The other factors are age, financial condition, investment holdings, investment experience, time horizon, liquidity needs, tax status, and investment objective.

Current Practice

Yet many investment firms still use only traditional indicators of investor suitability that focus on the ability to absorb losses and on investment horizon. Fidelity, for example, asks new clients for the following information: investment purpose, time horizon, investment objective, annual earnings, net worth, liquid assets, investment experience, and liquidity needs.

Other firms try to integrate risk tolerance into their investor profile questionnaires. Vanguard, for example, added five risk tolerance questions to the other six questions in their client Investor Questionnaire [3]. Kudos to them for including a real world question of how you would (and did) react in 2008 when stocks lost 31% of their value. Our rational choices are not always the same as our emotional ones during times of actual market adversity.

It is better to keep risk tolerance questions separate from questions like our time horizon, financial goals, and investment objectives. Risk tolerance and other investor profile questions should be evaluated separately to gain more insight into the differences between our financial goals and our behavioral biases. A robust risk tolerance questionnaire will tackle the behavioral elements of risk not covered by standard investor profile questions.
Risk Tolerance Questionnaire

A risk tolerance assessment can show us if our financial objectives are too conservative or too aggressive. Ignoring risk tolerance can cause us to abandon our financial plans during times of market stress. According to FinMetrica, 60% of the people who take FinMetrica's risk tolerance questionnaire (RTQ) find there is no strategy that will allow them to reach all their investment goals while adhering to their risk tolerances. In such cases, investors might want to use their risk tolerance profiles to revise their financial goals.
What to Do

How do we go about using RTQs? In the 1980s, I developed my own. I asked investors to choose between various financial outcomes. From this information, I constructed their risk profiles. I was surprised to see how much variation there was in risk tolerance. It was then I realized this information could be useful for portfolio planning purposes.

The science of psychometrics, which is the blending of psychology with statistics, has evolved since that time. You no longer have to do all the work yourself. There are several services, like FinMetrica and Riskalyze, that offer RTQs to financial planners. There is also a freely available online RTQ by Ibbotson Associates and Financial Planning Services Australia.

In addition, John Grable and Ruth Lytton, two financial planning professors, have an RTQ you can access online. Several research papers document the validity of their questionnaire:  Grabel and Lytton (1999) and Gilliam, Chatterjee, and Grabel (2010).
RTQ Issues

RTQs were criticized during the 2008 financial crisis for not anticipating how market turmoil could cause changes in risk tolerance. Critics argued that risk tolerance depends on market return and volatility. But Roszkowski and Davey (2010) present data collected pre- and post-crisis showing that the decline in risk tolerance was relatively small. What mostly changed was investors’ perception of risk. 

The authors conclude that risk tolerance is a stable personality trait. Sham (2008) makes the same point. Risk perception, however, changes because it is a cognitive appraisal of external conditions based on one's mental state.  This is good news since risk perception can be modified through more information and better education.

We cannot however look at risk tolerance just once and then forget about it. Risk tolerance does not take into account life changing events and shifting investment goals. We should periodically reevaluate risk tolerance, which is easy to do using the above tools.

Example of How to Use RTQs

I encourage investment professionals who license my proprietary models to use RTQs with their dual momentum clients. This can help them decide which model(s) best suit their investors' risk preferences while meeting their investment goals.

Other advisors should consider doing the same. If you manage your own account, you can follow the Greek maxim "Know Thyself" by using the RTQs by Ibbotson Associates or Grabel and Lytton. They can help you see if your investment portfolio is suited to your own risk tolerance and if, based on this, you should consider making some portfolio changes. Your financial and psychological health may depend on it.

[2] See Tversky and Kahneman (1979).
[3] Another publicly accessible questionnaire that combines risk tolerance with other factors is in the Financial Planning Practitioner’s Guide  by the Canadian Institute of  Financial Planners.

August 4, 2016

Useful Investment Blogs

As with many people these days, most of my investment information comes from the internet. It has taken me years to compile a group of research-oriented blogs and websites that I have found most useful. Here is my annotated list:

Investment Blogs

Quantocracy:  This is an aggregator of quantitative trading links to blog posts and research articles. It covers a broad range of ideas from coding to finance theory.

Abnormal Returns: This is another aggregator with short content summaries. It is broader in scope than Quantocracy. In fact, about one-quarter of the links have nothing to do with investing. The blog's daily emails make it easy to find articles of interest.

CXO Advisory: This website is a good way to learn about new investment research posted on the Social Science Research Network (SSRN). If you pay a modest subscription fee, you can read CXO’s analysis of these research papers which is a time saver. CXO sometimes does book reviews and researches other ideas, including momentum. 

Farnam Street: A variety of interesting topics by Shane Parrish.

Quantpedia: Useful for summaries and excerpts of investment research that may not show up on CXO. They use other sources besides SSRN, such as the Cornell University Library.

EconomPic Data:  Jake usually has thought provoking things to say, and he does some good research. His site is momentum friendly. Jake is also quite active on Twitter.

Alpha Architect: This is like an aggregator in that they put out posts almost every day. Some of these cover other people’s research without analysis. Other posts promote Alpha’s points of view.

Twitter is also a good source of investment information. Not only do those followed on Twitter offer their own insights, but they retweet and comment on worthwhile information from others. Here are the Twitter handles of the above bloggers plus my own:

Quantocracy @quantocracy
Tadas Viskanta @abnormalreturns
CXO Advisory @CXOAdvisory
Shane Parrish @farnamstreet
Jake @EconomPic
Gary Antonacci @Gary Antonacci

Here are others I like who have many followers:

Meb Faber @MebFaber
Vanguard Advisors @Vanguard_FA

These have fewer followers but deserve more:

Samuel Lee @etfsamlee
The Leuthold Group @LeutholdGroup
Ned Davis Research @NDR_Research

There are other excellent investment bloggers and Twitter peeps. I follow around 90. Any more and I would not have time to read them all. As with other things in life, you need to find the right balance.

June 13, 2016

Smart Beta Is Still Just Beta

Some say that bull markets climb a wall of worry. This is good news for those already in the market. Worriers will help the market go higher later when they finally decide to jump on the bandwagon. Herding  and regret aversion (fear of losing out on future profits) should eventually overcome loss aversion.

Investors Skeptical

The iconic investor and money manager, Sir John Templeton, said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”  The current bull market in U.S. stocks, though longer in duration than many previous bull markets, has not yet garnered a lot of investor confidence. It is still in the skepticism stage. Perhaps investors have remained fearful due to the two bear markets of the past 20 years when stocks lost half their value each time.

Even though the U.S. stock market is around new highs, investors are still skeptical about further gains lying ahead. According to the AAII Sentiment Survey, at the end of May the percentage of individual investors optimistic about stock market gains was at its lowest level in 11 years.

Investment flows have also reflected lackluster investor interest. Only 52% of U.S. adults are invested in the stock market. This is tied with 2013 as the lowest level in 16 years. The cumulative flow into mutual funds and ETFs is 25% lower than it was 18 months ago. Among professional money managers, allocations to U.S. equities are near an 8-year low, and cash levels are at their highest level in 14 years, according to the latest Bank of America Merrill Lynch Global Fund Manager Survey.

Overvalued Stocks

With the U. S stock market at new highs, sentiment has shifted from the market being in a “distributional top” pattern to it being “overpriced.” High valuations may mean lower expected returns over the next 10 years, but it does not mean valuations cannot get even higher.  In April 1996, the Shiller CAPE ratio was at 25, near where it is today. But the CAPE ratio continued to rise over the next 3 years until it reached a high of 43 in November 1999. The S&P 500 gained another 138% during that time.

From that level, the S&P 500 lost 9% over the next 10 years. But look at what happened with our Global Equities Momentum (GEM) model that took advantage of shorter-term fluctuations in stocks and bonds to earn extraordinary returns during that time.

Source: Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Please see our Performance and Disclaimer pages for more information.

Smart Beta and Low Volatility

Since most investors are not familiar with the benefits of dual momentum, they have gravitated toward factor-based “smart beta” funds. According to Morningstar, the amount of assets in smart beta funds grew from $103 billion in 2008 to $616 billion at the end of 2015. As of October 1 of last year, $110 billion of that was in “low-volatility” funds, which investors may think lessen the risks of investing.

BlackRock projects that smart beta ETF assets will reach $1 trillion globally by 2020 and $2.4 trillion by 2025 [1]. This is an annual growth rate of 19%, double that of the overall ETF market. Low volatility and factor (multi and single) funds are expected to be key drivers of this growth. They represent more than 60% of new smart beta inflows through 2025.

Smart beta ETFs saw $31 billion in new fund flows globally in 2015 with minimum low volatility ETFs accounting for $11 billion of it.  The largest of these low volatility ETFs, the iShares Edge MSCI Min Vol USA ETF (USMV) has $13 billion, and 40% of those assets were contributed just this year.

The large inflow of capital into low volatility stocks has bid up the return of USMV for 2016 to 8.6% versus 3.5% for the iShares S&P 500 ETF (IVV). The P/E ratio of USMV on a trailing 12-month basis is now 24.8 versus 18.8 for the S&P 500. The P/B ratio of USMV is 3.2 versus 2.5 for the S&P 500. Arnott et al. (2016) show that high valuations of factor and smart beta strategies are negatively correlated with future returns. Investors jumping on the low volatility bandwagon now may be disappointed when prices return to more normal levels.

Smart Beta Issues

What about the advantages that smart beta in general are supposed to give investors? A Vanguard study showed that smart beta outperformance relative to cap-weighted benchmarks from 2000 through 2014 can be traced to systematic risk-factor exposures. After accounting for market, size, and value risk factors, none of the smart beta strategies showed results that were significantly different from zero. In most cases these strategies produced negative excess returns after accounting for their risk-factor exposure.

Source: "An Evaluation of Smart Beta and Other Rules-Based Active Strategies", Vanguard Research, August, 2015

Glushkov (2015) looked at the performance of 164 smart beta ETFs from 2003 through 2014 with respect to benchmarks based on size, value, momentum, quality, beta, volatility and other risk factors. He also found  no conclusive evidence that smart beta ETFs outperformed their risk-adjusted benchmarks over this period.

Data Overfitting

Backtest overfitting is also a serious problem for smart beta strategies. Suhonen et al. (2016) examined 215 smart beta strategies across five asset classes. They found a median 73% deterioration in the Sharpe ratio between backtest and live performance periods.

Source: Suhonen et al. (2016)

The deterioration of Sharpe ratios was most pronounced among the most complex strategies. Their reduction in Sharpe ratios was 30% higher than those of the simplest strategies. As other research has shown, intensive back testing and complex modeling often pick up more on noise patterns in the data than on the underlying signal processes.

Unrecognized Risks

Very few still believe that the markets are perfectly efficient. Since there is plenty of contrary evidence now, many think it is not difficult to do better than the market. But we should remember that smart beta is still just beta. It may not give higher risk-adjusted returns.
Furthermore, we can define risk in different ways. Academics equate risk with volatility, but that is too limiting. Long Term Capital Management, founded by academics, did well by exploiting derivative mispricing. But unforeseen liquidity risk wiped out all their gains and most of their capital. It also nearly led to the collapse of the world’s financial system.[2]

There are also unrecognized risks in other investment factors. Some people were surprised that value and momentum were left out of Fama and French’s latest factor pricing model. But value investing has had eight steady years of severe benchmark underperformance. I call this kind of tracking error “relative performance risk.” It may explain why investors need higher returns from value investing.

There are unrecognized risks with stock momentum investing as well. Momentum works best with focused portfolios of 100 or fewer stocks and when portfolios are rebalanced frequently. There is now substantial capital invested in single and multi-factor funds that use stock momentum. More capital is coming into momentum at an increasing rate. Every month Alpha Architect freely discloses on their website the top 100 momentum stocks. But stock momentum is a high turnover strategy with 25-30% of the portfolio typically replaced with every rebalance. There may be a significant scalability problem when hundreds of billions of dollars tries to enter and exit the same 25 or 30 stocks each month or quarter.

Momentum also favors volatile stocks with wide bid/ask spreads. Wide spreads combined with high portfolio turnover lead to high transaction costs that can eliminate much of the excess return we see when we backtest momentum strategies.


Markets are not easy to beat when you consider all the risks. Many investors in smart beta or other actively managed funds pay higher expense ratios and still underperform. Compare that to the cap-weighted Schwab U.S. Large-Cap ETF (SCHX) that holds 750 stocks. Its annual portfolio turnover is just 4%, and its expense ratio is only .03%. That makes SCHX hard to beat as a buy-and-hold investment.

As small companies grow and prosper, they naturally become an increasing part of a cap-weighted portfolio, while poor performers receive less weighting over time. Cap-weighting lets your profits run on and cuts your losses short.

For example, the largest stock holding in the S&P 500 index is Apple. It is worth more than General Electric, General Motors, and McDonalds combined and more than the 100 smallest holdings combined. How many bought Apple in December 1982 when it became part of the S&P 500 index at a price of 48 cents a share (adjusted for dividends) and have held it continuously since then?  Investors often prefer more complicated approaches that sound good, like smart beta or multi-factor funds, but simpler often is better.

[1] BlackRock Global Business Intelligence, May 10, 2016
[2] See When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein (2000).

April 28, 2016

What You Should Remember About the Markets

Because I have been an investment professional for more than 40 years, I sometimes get asked my opinion about the markets. These questions usually come from those without  a systematic approach toward investing. Here are some typical questions and answers:

Question: How much do you think the stock market can drop?
Response: 89%
Question: What?!!
Response: Well, that is the most it has dropped in the past. But past performance is no assurance of future success, so I guess it could go down more than that.

Question: I just looked at my account, and it is down. What should I do?
Response: Stop looking at your account.

Question: What are you doing now?
Response: What I always do … following my models.

After these responses, I am usually not asked any more questions.

Simple But Not Easy

Some say investing is simple, but not easy. This is due to myopic loss aversion. This combines loss aversion, where we regret losses almost twice as much as we appreciate gains, with the tendency to look at our investments too frequently.

We should remember that we cannot control the returns that the markets give us, but we can control the risks we are willing to accept. If we do not have systematic investment rules, it is easy to succumb to emotions that cause us to buy and sell at inappropriate times. The Dalbar and other studies show that investors generally make terrible timing decisions. The most common mistake investors make is to pull the plug on their investments, often at the worst possible times.

But investing does not have to be difficult if we have firm rules in place to keep us in tune with market forces. A sailor cannot control the wind, but she can determine how to best take advantage of it to get her where she wants to go.

Trend Following

I have found an important principle to keep in mind is the old adage “the trend is your friend.” As some say, "the easiest way to ride a horse is in the direction it is headed." To remind me of how important it is to stay in tune with the long-term trend of the markets, I have this on my office wall:


Many are familiar with that saying, but not that many have the discipline to always follow it. Much of Warren Buffett’s success is because he had the vision to stick with his approach over the long run. Buffett said, “You don’t have to be smarter than the rest. You have to be more disciplined than the rest.” This discipline applies not only to staying with your positions. It also means re-entering the markets when your approach calls for it, even though uncertainties may still exist.

What gives me the ability to stay with the long-term trends of the markets? First is knowing how well trend following has performed in the past.

Absolute Momentum

There are different approaches to trend following, such as moving averages, charting patterns, or other tactical indicators. The trend following method I prefer is absolute (time-series) momentum. It has some  advantages over other forms of trend following. First, it is easy to understand and to back test. It looks simply at whether or not the market has gone up or down over your look back period.

In my research going back to 1927, absolute momentum had 30% fewer trades than comparable moving average signals. From 1971 through 2015, our Global Equities Momentum (GEM) model had 10 absolute momentum trades that exited the stock market and had to reenter within a 3 month period. A 10-month moving average had over 20 exits and reentries. The popular 200-day moving average had even more signals. 

You do not need to enter and exit right at market tops and bottoms to do well. In fact, if your investment approach is overly sensitive to price change and tries to enter and exit too close to tops and bottoms, you will often get whipsawed.

Because of whipsaw losses and lagging entry signals, trend following often underperforms buy-and-hold during bull markets. This is the price you pay for the protection you get from severe bear market risk exposure.

Since absolute momentum has a low number of whipsaw losses, the relative momentum part of dual momentum can put us ahead in bull markets over the long run. Absolute momentum does its job by keeping us largely out of harm’s way during bear markets. The tables below show how absolute momentum, relative momentum, and dual momentum (GEM) performed during bull and bear markets since 1971. Absolute momentum by itself underperforms in bull markets due ot whipsaws and lags. But adding in relative momentum puts us ahead over time even in bull markets. Relative momentum by itself has large bear market drawdowns. But adding absolute momentum to it turns bear market losses into modest profits over the long run.

Bull and Bear Market Performance January 1971 - December 2015 

Bull Markets
S&P 500
Abs Mom
Jan 71-Dec 72
Oct 74-Nov 80
Aug 82-Aug 87
Dec 87-Aug 00
Oct 02-Oct 07
Mar 09-Jul15
Bear Markets
S&P 500
Rel Mom
Jan 73-Sep 74
Dec 80-Jul 82
Sep 87-Nov 87
Sep 00-Sep 02
Nov 07-Feb 09
Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Please see our Disclaimer page for more information.


My research paper, “Absolute Momentum: A Simple Rule-Based Strategy and Trend Following Overlay” showed the effectiveness of absolute momentum across eight different markets from 1974 through 2012. Moskowitz et al (2011) demonstrated the efficacy of absolute momentum from 1965 through 2011 when applied to equity index, currency, commodity, and bond futures. In “215 Years of Global Asset Momentum: 1800-2014,” Geczy & Samonov (2015) showed that both relative and absolute momentum outperformed buy-and-hold from 1801 up to the present time when applied to stocks, stock indices, sectors, bonds, currencies, and commodities.

Greyserman & Kaminski (2014) performed the longest ever study of trend-following. Using trend following momentum from 1695 through 2013, they found that stock indices had higher returns and higher Sharpe ratios than a buy-and-hold approach. The chance of large drawdowns was also small compared to buy-and-hold.  The authors found similar results in 84 bond, currency, and commodity markets all the way back to the year 1223! Talk about confidence building. These kinds of results give me the ability to stay with absolute momentum under all market conditions.

Market Overreaction 

I have some clients though who are less familiar with trend following. They still get nervous during times of market stress, such as August of last year. They need to understand that stocks do not trend all the time. The stock market can overextend itself and mean revert over the short run. During such times it is important for investors to stay the course and not overreact to short term volatility.

To remind me to remind others about such short-term mean reversion, I have this coffee mug in my office:


This tells me to ignore market noise and calmly accept occasional market overreactions that are often followed by mean reversion.

There is no way to get rid of short-term volatility and still earn high returns from our investments. We should, in fact, embrace short-term volatility since it is what leads to superior returns over the long run.

What to Remember

Rigorous academic research confirms the existence of trend persistence and short term mean reversion. Whatever your investment approach, if you respect these two forces you should be able to invest with comfort and conviction. Being aware of these principles gives us the two qualities required for long run investment success. First is the discipline we need to follow one's proven methods unwaveringly.

The second is patience.

Warren Buffett said the stock market is a mechanism for transferring wealth from the impatient to the patient. Like Buffett, we also need to patiently accept inevitable periods of short-term volatility and underperformance with respect to our benchmarks.

If you have trouble always remembering the concepts of trend persistence and mean reversion, then do what I do. Get yourself a poster and coffee mug.