Illumination through research

10Aug06

One of the themes of this site is that investing is hard. Not necessarily because successful investors need to be geniuses. Rather it is the psychological dimension of active investing that leads to the downfall of a majority of investors. Given our brain’s penchant to seek our patterns, even when they are spurious or non-existent, we are constantly facing situations with faulty information. These distilled patterns come at us as intuition and can despite our best efforts be as detrimental as beneficial.

One way investors can counter this effect is to rigorously test their investment hypotheses. This of course presupposes that you can distill your investment method into a well-defined series of steps. While this may be difficult it is in fact essential to taking the next step. This is not altogether different than many other human endeavors.

For example, cooking knowledge is passed down across time and space by the use of recipes. The best recipes provide detailed instructions on how to combine raw, base ingredients into a finished dish. Master chefs are seemingly able to “improvise” only because they have internalized a massive amount of recipe-like data. Acquiring this expertise requires both time and active learning.

Mark Mahorney at Stockblog.com raised the topic of cooking as an apt investing analogy. Mark finds a cooking magazine is in fact a good representative of how investors should go about their approach to research.

Few traders take the approach to testing markets that is applied to cooking by the Cook’s Illustrated chefs. Why? Because it requires a lot of seemingly wasted effort. Failed strategies and tests are trashed like so much junk mail. But no doubt testing, refining, and optimizing trading strategies in a scientific like manner is worth the effort and will payoff just as you would turn out a better dish in the kitchen tweaking a recipe.

A great example of how market intuition can lead us astray is the notion that now that the Fed has indicated is has paused, or even stopped, its rate hikes, a green light now illuminates Wall Street. While not unreasonable, the historical evidence contradicts that intuition. Barry Ritholtz writing at TheStreet.com has accumulated a series of studies on the subject.

While the market may react positively in the short run, over the intermediate term a Fed stoppage has lead to lower prices in a majority of cases. While this time it might be different it is worthwhile having the correct facts on hand.

Quantitative data is by no means a panacea. It is oftentimes the case that studies of related phenomena can lead to radically different conclusions. For instance the Fed study would lead you to believe the market is in for a rough few months. However, the state of the presidential election cycle would argue just the opposite.

Eddy Elfenbein at Crossing Wall Street has poked around the data on the subject of the presidential election cycle. According to his data we are soon approaching one of the most positive periods for the market. If we are to believe this data it puts in a bit of a quandry. The two sets of data (Fed and presidential election cycle) are telling us two different stories. Although quantitative research is useful it is not always unanimous.

Two sites that accomplish this task well are CXO Advisory Group (sporting a new look) and TraderFeed. Although they both approach the markets with a certain quantitative rigor their methods are quite different. CXO does an excellent job of reviewing academic research on a wide range of investment topics. The focus is decidedly longer term in nature. TraderFeed on the other hand has a shorter-term, trading oriented focus relying on self-generated insights. Where the two are similar is that they often find common market lore or their own intuition mistaken as often as it is confirmed.

We will reiterate our initial statement: active investing is hard. Our brains and the accumulated lore of Wall Street can all serve to leads us down dark investment alleys. A rigorous approach to the markets can serve as a flashlight to illuminate this oft treacherous path.

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