Factoring In “Intuition”
When we’re discussing our investment philosophy, we love to hear questions that open up more around why we invest the way we do. Because the reality is that most individual investors don’t really even have an investment philosophy beyond trying to get the best return.
Occasionally during these conversations, we talk about how we pursue “factors” of return that are persistent, pervasive, robust, implementable and intuitive. We wanted to briefly cover what these mean, and especially the one labeled “intuitive”. How could intuition have anything to do with an investment philosophy?
First off, how do we define what we mean by a “factor” of return? Academic and industry research has shown there are certain ways we can group securities with similar characteristics (i.e., factors), and then use those characteristics to find what parameters get rewarded (i.e., return). For example, we can group stocks into two categories based on size: In one group, we can put large market capitalization stocks, and in the other, we can put small market capitalization stocks. We can then look at how large stocks have historically performed versus small stocks and determine if we should invest in one group versus the other. Research has shown that small stocks outperform large stocks over the long term, and we call this the size factor of return.
We can easily apply our “philosophy test” by asking if the size factor is persistent (small stocks outperformed large over many different historical time periods), pervasive (small stocks historically outperformed large stocks in markets all over the world), robust (small stocks historically outperformed large stocks by a meaningful amount), implementable (it is easy to sort stocks based on size and it doesn’t cost much to buy small stocks) and intuitive (small stocks are riskier than large stocks and investors should be rewarded for taking that risk). We should point out that even when passing such rigorous tests, we wouldn’t only invest in small stocks of course. But this factor can remind us to have an appropriate amount of small stocks in a portfolio.
We’ll now go back to our initial question; what would be an example when something isn’t intuitive? One way would be to group stocks by the first letter of the company’s name. Hypothetically, let’s say we did the research and found that investing in companies that begin with the letter “A” produced the best historical return versus all the other letters in the alphabet. To make our case, we might say that Apple, Amazon, and Alphabet (the parent company of Google) are all part of the strategy, and they have all performed well over the past decade.
Yet this is a silly exercise, because grouping companies based on a letter doesn’t make sense, and, therefore, isn’t intuitive. Companies that begin with the letter “A” aren’t successful (or unsuccessful) because they named their company with that letter, and letters tell us nothing about the risk we are taking.
We want the bedrock of our investment philosophy to make practical sense and to be heavily supported by historical evidence. We are dealing with your life savings and how those savings can help you reach your life goals. We don’t want to leave your goals up to chance, a good sales story or some current trend.
If you have any questions about your plan or investments, please don’t hesitate to call. We are here to help you reach your financial life goals!
Long-term investing neither assures a profit nor guarantees against loss in a declining market. Past performance does not guarantee future results. Stock investing involves risks, including increased volatility (up and down movement in the value of your assets). All investing involves risk, principal loss is possible.