I love to surf around and discover articles by following Alice down the rabbit hole – meaning – start down a path and just keep going. I was reading an excellent post by Woodshedder over at ibankcoin.com this morning on position sizing. I think the post and Van Tharp articles (part 1 and part 2) it references are a good source for understanding position sizing and the effect on a given system. In fact, I think they should be required reading for any aspiring trader.
The Woodshedder post referred me to a blog I was unaware of – Max Dama – a student/quant. Max is obviously very, very smart (about 10x my brain power judging by his blog). Max was profiled in a piece in Porfolio (also available via Wired) on the rise of quant-based strategies in the financial world. That article referenced Legend Advisory – who offer a quantitative approach to asset allocation. They use an artificial intelligence model for determining the asset allocations between different sectors and styles – think “should I be in financials?” or “will growth outperform value?”.
I did some more searching on Legend and came across an article in Allbusiness that detailed some of their predictions from December 2007. Here’s what I find fascinating – for all their math and study, two of their predictions stood out to me as being so, so wrong (and they had others that were right) that it made me question their whole approach. My comments are [in the brackets].
1. The financial sector should outperform in the second half of 2008. [My comment - wow - stunningly wrong].
2. Corporate earnings growth should continue to decline. [Interesting and correct - but what do you do with it?]
3. P/E multiple expansion will result from lower interest rates. [I don't have the tools to look at this one to know if it right or wrong - my guess is that it is correct but again, what do I do with it?]
4. The US Dollar should continue to weaken throughout the year, but could reverse its course before the end of 2008. [Correct!]
5. After underperforming the broader markets for almost 6 years, healthcare should surprise investors (positively). [Healthcare outperformed the general market, but still declined - I'll give them half-right.]
6. The real US economic growth rate (GDP) will decline in 2008, below its historical trend. [Correct - but then how could you say that financial would do better given that the market is so dependent on the performance of financials?]
7. Growth stocks should outperform value stocks in 2008. [Value actually outperformed growth, at least in the small cap arena, for more than half of 2008]
8. The S&P 500 index should reach 1625 by mid year, 2008. [Stunningly wrong - the index was at 1504 on Dec 7th, the time of the writing of the article]
All of this isn’t to knock Legend specifically – most models (including my own) did not do well in the radically different market that 2008 gave us. They also may be making some predictions here that didn’t make it into their client’s portfolios or were altered significantly during the year.
The point is this: don’t be too impressed by financial firms that throw a lot of whiz-bangy mathematical jargon out there. Hell, I’m not that good at math, and, at first, I thought Legend’s approach sounded very interesting. But in looking at their results, I’m reminded that you can throw all the math you want at the financial puzzle and still end up with a stinker.
It also reinforced, in me, the idea that everyone has to be responsible for their financial future. You can’t put your financial future on autopilot with someone else and not be involved. I am consistently surprised by the number of people, in surveys, that spend more time planning vacations than planning their finances. I am also consistently depressed by the total lack of education prior to graduation from high school and college on these issues.
It sounds all well and good to let a computer model determine everything – but at the end of the day, much of what these firms put out there is mathematical masterbation. Just remember that next time someone tells you they’ve got a model that can solve all your problems.