What Works Best?
Several readers have asked, of all the active investing/trading strategies investigated by research summarized in the blog, which ones that individual investors can practically implement work best. With reservations (because of all the uncertainties, statistical biases/criticisms and contradictory evidence to which the research is subject), here are some best guesses:
The best active investing/trading strategies rely on tendencies of financial markets, social systems of individuals, to overreact or underreact systematically to new information. Confirmation bias sustains misreaction. Misreaction is complex: (1) misreactions to good/bad information may be asymmetrical in both degree and speed; and (2) misreaction may be path dependent, such that similar new information may lead to different misreactions under different market conditions. To the extent they are predictable, misreactions present complementary momentum and value trading/investing opportunities. Momentum and value are aspects of the same sloshing of investment funds from asset class to asset class, and from asset to asset within class. Because of misreaction dynamics and asymmetries, one must be more nimble (higher portfolio rebalancing frequency) to exploit momentum than value, and to exploit overvaluation than undervaluation. Many technical trading schemes relate to attempts to detect investor misreaction.
Time-limited derivatives consistently (and asymmetrically) impound some misreaction in their prices.
There are some cultural rules less fundamental to human nature (when people pay taxes, rules for capital gains taxation, when people make retirement fund contributions, political cycles) that systematically affect asset prices. These rules lead to calendar effects.
Data snooping bias and defects in statistical assumptions are pervasive (infecting popular technical analysis most severely) and substantially dent the credibility of the body of investing/trading research (see Investing Demons).
Individual investors can play momentum and value at the asset class level (via low-cost funds, keeping search and trading costs down) at various levels of diversification across asset classes. Some research relevant to this approach is:
A Few Notes on The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets …The Ivy Portfolio offers investors a well-reasoned, well-documented, easily understood and easily implemented approach to long-term, self-directed portfolio management based on disciplined asset class diversification enhanced by momentum. While investors should expect to underperform the modeled level of returns, the approach has considerable support from formal research.
Combining Value and Momentum Across Asset Classes …a portfolio that combines value and momentum strategies across global equity markets and other asset classes may offer investors relatively high returns with low volatility.
The Decision Moose Asset Allocation Framework …the Decision Moose asset allocation framework may offer investors a way to beat buying and holding broad U.S. equity indexes by occasionally trading to the “hottest hand” from a broad set of asset classes.
Combined Value-Momentum Tactical Asset Class Allocation …value and momentum investing may work across a broad range of asset classes, and the two effects are independent enough that combining them may yield incremental outperformance.
An Investor’s Asset Class Momentum Trading Strategy …an asset class momentum trading strategy may favorably tilt the risk-reward playing field for investors who systematically apply it.
In summary, momentum and value strategies applied at the asset class level via low-cost funds may be among the best for individual investors.
To reiterate, the above observations are just best guesses regarding the kind of practical investing/trading strategies that work best. Plausible arguments counter to them exist. Defects in research methods generally imply that results overstate expected returns. “Best” is also a function of individual goals and constraints.
