Sometimes even the best of ideas are only good in theory because they are impossible to implement in practice. This holds true to the financial world as well.
Academic financial research generates hundreds of research papers each year highlighting potential ways for investors to get a possible insight on the direction of the stock market. Many of these findings are found using less than rigorous scientific standards such as using the alignment of planets, who holds political power in Washington or using weather to predict future stock movement.
However, even when a research item held to rigorous standards uncovers a possible solution, it can not be followed when the research is brought into the real world. Thus while sounding like a good idea, they are unable to provide investors with any actionable insight.
One approach that has attracted considerable attention in recent years is adjusting investments based on the CAPE ratio – the cyclically adjusted price/earnings ratio. This approach developed by academics Robert Schuller of Yale and John Campbell of Harvard seeks to provide investors with a way to improve their portfolio performance by over-weighting stocks (owning a higher percentage) during periods of low valuation and under-weighting stocks (owning a lower percentage) during periods of high valuation. Seems simple enough, no?
Well, it turns out that the challenge of profitting from this approach and many other quantitative indicators is to design a trading rule to identify the correct time to under-weight or over-weight stocks. It is not enough to know that stocks are above or below the long-term average valuation.
How far above valuation before investors should reduce equity exposure?
And at what point will stocks be sufficiently attractive for repurchase – below average? Average? Slightly above average?
It may be easy to find the rules that have worked in the past, but much more difficult to achieve success with following the same rule in the future.
These research theories remind me of the children’s fable:“Belling the cat”. It is the Aesop fable where mice who have seen other mice getting picked off by a cat decide to call a meeting. The reason for the meeting is to devise a plan so they did not continue to lose members of their clan to the cat. After much discussion, a young mouse devised a plan.
The plan was a simple plan. They would tie a bell around the cat’ s neck which would alert them when the cat was nearby. This would allow them time to exit before the cat was able to pounce. Many of the mice were surprised that they had not thought of this great idea earlier.
However, one wise mouse asked the following question:
Who will bell the cat?
For it is one thing to say that something should be done, but quite a different matter to successfully execute it. Or in the case of these financial research papers, it is one thing to pick out tactics that may work in a research lab, but quite another to implement them in the real world.
A successful timing strategy is the fountain of youth of the investment world. For decades financial researchers have explored dozens of quantitative indicators as well as various measures of investor sentiment in an effort to discover the ones with predictive value. The performance record of professional money managers over the past 50 years offers compelling evidence that this effort has failed. It’s much harder to “bell the cat” in reality.
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