On the appeal of magical thinking

I like market-capitalization-weighted passively indexed mutual funds for a lot of reasons:
  • They're cheap! Vanguard offers a S&P 500 and total US equity fund, each with a 0.05% expense ratio, a total international stock fund with a 0.12% expense ratio, a total US bond fund with a 0.06% expense fee, and a total international bond fund with a 0.14% expense ratio. That's cheap!
  • They don't trade much! Market cap-weighted funds don't have to trade in and out of stocks very often to meet their investment objectives, keeping trading costs to a minimum.
  • They are practically guaranteed to meet their investment goals! If you make regular contributions to a market cap-weighted passive index fund, you will buy in at the average price during your investing lifetime. If you make regular withdrawals from a market cap-weighted passive index fund, you will sell your investments at their average price during your withdrawal lifetime.
But I understand the problems with market-capitalization-weighted passively indexed mutual funds too:
  • They buy expensive stuff when it's expensive!
  • They make investments based on the popularity (market cap) of companies instead of the quality of their business operations!
So I also understand the appeal of so-called "fundamental-weighted" index funds. Instead of weighting by market cap, they weight by "some other" fundamental value of the underlying business: sales, revenue, profit, book value, whatever.

These funds are more expensive than the market-cap-weighted funds mentioned above, but not by that much. Charles Schwab offers a "Large Company" fundamental-weighted fund for 0.32% (+0.27% compared to Vangaurd's passive fund), a "Broad Market" fund for 0.32% (+0.27%), an "International Large Company" fund for 0.32% (+0.2%).

If you believe in your heart-of-hearts that cap-weighting is the Wrong Way To Index, and that fundamental-weighted funds will outperform cap-weighting by more than the amount of the increase in the expense ratio, that seems like a perfectly reasonable position to take. Good luck.

What I've noticed more and more in the podcasts I've been listening to is an obsession not with the correct way of designing a low-cost, passive index fund, but with simply magical thinking.

Magical thinking usually takes one of two forms. The first is the argument for "magic by necessity." This argument says something like, "it would be great if passive indexed investing could give you the results you need, but unfortunately with price/earnings ratios well above the historical average, you need magic to generate the necessary returns in your portfolio." Meb Faber is one of the biggest advocates for this brand of magical thinking.

The second form could be called "magic by regression analysis." This argument says, "if you are willing to accept higher volatility in your portfolio, you can generate higher risk-adjusted returns." In other words, if you are willing to follow the sorcerer's system through all market ups and downs, you will generate returns that more than compensate for the increased volatility in your portfolio.

Specifically, I'm talking about so-called "trend-following" strategies. This magical thinking takes the following form: "While you might expect to get higher returns by buying low and selling high, in fact you get higher returns by buying things that are going up and selling things that are going down, as long as you put complete faith in the strategy."

The reason I call this "magical thinking" is that it relies entirely on faith — specifically, faith in the design and implementation of the strategy.
  • Market cap weighting requires no faith whatsoever: you will buy the entire market at its current price, and you will sell the entire market at its current price.
  • Fundamental weighting requires faith in the design, but not implementation, of the strategy: you have to trust that the fund managers are using the correct fundamentals to weight their fund, but then they are supposed to rebalance the fund "automatically," although they'll incur some trading costs while doing so.
  • Trend-following requires not just belief in so-called "momentum," but also faith that the fund managers are using the correct measures of momentum, and also that they'll implement their momentum strategy correctly.
Look: maybe "momentum" is a real phenomenon in the marketplace. Maybe a subset of managers have selected the correct tools to identify momentum. And maybe a subset of those managers have developed the correct strategy for trading in and out of momentum.

But if you both believe in momentum and believe you can identify the correct subset of that subset of manager, you're indulging in magical thinking.
 

RWC75

Level 2 Member
Oh, man... I gotta disagree with you about defining momentum or trend-following strategies as "magical thinking". Momentum is one of the most well documented and pervasive of the "market anomalies" or ways to generate outperformance across time and markets, in academic studies as well as actual market performance. I also strongly object to the idea that Meb Faber's position that you need more than what passive indexing will provide for you in order to generate above-market returns - for the simple reason that a passive index strategy IS the basic market return. It is therefore not at all incorrect to state that in order to "beat" the market you need to do something different.

Now - I will totally agree that momentum doesn't work in all market regimes, and if you actually read Faber's work and others in the momentum investing space, they point out that there will be multi-year time periods where momentum will UNDERPERFORM the broad market or a basic 60/40 allocation. The basic idea is that OVER THE FULL MARKET CYCLE momentum will outperform primarily by minimizing drawdowns during the major market downturns.
 
RWC75,

When I say Faber says you "need" to use alternative strategies to beat the market, my point is that he is arguing that you need to do so because expected market returns are currently expected to be low. Obviously it's necessary to "do something different than the market" to beat the market, but it's not necessary for people to choose to do so. His argument is that people should choose to do so, because of low expected market returns. Hence, magic by necessity.

As for "market anomalies" and magical thinking, what I'm saying is that it's not enough to believe that momentum as a strategy in general outperforms the market. You also have to believe it outperforms the market by more than the costs of implementing the strategy. And THEN you have to believe that you have correctly identified the "right" momentum strategy (200 day moving average? 10 month moving average? Intraday/daily/weekly/monthly prices?). And THEN you either have to believe that you've selected a manager who has the same strategy or believe that you can implement the strategy on your own. And THEN you have to believe that in addition to all of the above, you will actually stick with the strategy through entire, long, grinding market cycles.

If you believe all those things, you are certainly justified in following a momentum strategy. But if you believe all those things, I humbly submit you are indulging in magical thinking.

Of course, the good news is that as long as people like me keep passively indexing for all the reasons stated above, market anomalies will keep appearing for the faithful to take advantage of!
 

RWC75

Level 2 Member
As for "market anomalies" and magical thinking, what I'm saying is that it's not enough to believe that momentum as a strategy in general outperforms the market. You also have to believe it outperforms the market by more than the costs of implementing the strategy. And THEN you have to believe that you have correctly identified the "right" momentum strategy (200 day moving average? 10 month moving average? Intraday/daily/weekly/monthly prices?). And THEN you either have to believe that you've selected a manager who has the same strategy or believe that you can implement the strategy on your own. And THEN you have to believe that in addition to all of the above, you will actually stick with the strategy through entire, long, grinding market cycles.

If you believe all those things, you are certainly justified in following a momentum strategy. But if you believe all those things, I humbly submit you are indulging in magical thinking.
Again, I disagree.

First of all, there's widespread agreement in what momentum time periods are effective - inside of 30 days, you generally get mean reversion; out to about a year, trends tend to persist. Moving average strategies are similar but not the same thing, and again, broad agreement on 200DMA / 10 month MA.

Second, implementation doesn't have to be expensive, and you don't have to select the right manager to implement it. Faber's strategy is more than simple enough to implement using low cost index ETFs or no-load Vanguard funds, even for a relative layman.

Third, the fact that a fund or manager underperforms an index or another strategy doesn't in any way indicate that the manager or fund failed to implement their own strategy well. As I mentioned above, ANY strategy will have periods of underperformance or overperformance against any other strategy. There will be times that small cap stocks outperform large cap, domestic outperforms emerging market, commodities outperform real estate, and value outperforms momentum. Which doesn't mean that those strategies don't work - it's simply an acknowledgement that no strategy works well in all market regimes. Not even passive indexing (which massively underperformed a simple 200DMA strategy from 2007-2010).

Fourth, the ability for someone to stay to a strategy through thick and thin isn't unique to momentum strategy - it is equally applicable to buy and hold / indexers as well. How many folks stayed out of the market after the 2007-09 crash? How many missed a massive rally since the bottom? How many truly kept dollar cost averaging the whole way down?

None of which is at all "magical thinking". What you're talking about is being aware of normal human behavior, and acknowledging that sticking to strategies is hard as hell to do for anyone.
 
Third, the fact that a fund or manager underperforms an index or another strategy doesn't in any way indicate that the manager or fund failed to implement their own strategy well.
I think the grounds of our disagreement are clear so I'll just reply to this point.

I am not saying that for a strategy to be "successfully implemented" it has to beat the market 100% of the time. That would be crazy.

I am saying that there is a difference between (1) a correctly implemented strategy that fails to beat the market 100% of the time (as it certainly will) but beats the market "over the full market cycle" and (2) a strategy that, if implemented correctly, would beat the market "over the full market cycle" but is in fact implemented incorrectly, either because you chose the wrong manager (choosing managers is hard) or because you happened to implement the strategy incorrectly out of inexperience, illness, distraction, or human nature, which you point out includes "sticking to strategies is hard as hell to do for anyone."

In addition to believing that momentum is a strategy that would beat the market "over the full market cycle" you ALSO have to believe you can choose the correct manager to implement that momentum strategy or believe you can implement it successfully yourself.
 

RWC75

Level 2 Member
Which, again, isn't "magical thinking" at all. It may be overconfidence or hubris, but it's not "magical thinking". Moreover, there is absolutely no reason whatsoever that it can't happen.

I totally get your skepticism, I really do, and chasing "hot managers" and "hot funds" across the mutual fund or ETF industry is a massive cause of investor underperformance, and a solid argument to implementing a simple strategy like 60/40. That does not, however, in any way render invalid the idea that a more complex strategy can be implemented correctly and can outperform over a full market cycle. It's a challenge to overcome innate human impulses, but that's kinda the whole point of the journey of becoming a successful investor or trader in the first place.
 
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