“If it’s in the data.”
Cliff Asness was once a student of Nobel Prize Winner, Eugene Fama at the Chicago School of Business. Fama was not only Cliff’s hero but also his Professor.
Eugene Fama at the time was on his way to becoming one of the fathers of modern finance. This was someone who Cliff deeply respected. There was however a problem for Cliff, as part of his recent studies he had become very interested in a pattern with investments that weren’t easily explained by Fama’s recent framework on financial models. Fama’s theory of Efficient Markets and factors were all ‘risk-based.’ They all relied on a logical explanation of the world. Investors demanding higher returns because they were taking more risk:
‘Value stocks’ expect a higher return as they are lower priced stocks compared to their cash flow. They are riskier and often in distressed or unloved industries so investors will pay less for the stocks so they have higher cash flows and expect to produce higher returns.
‘Small stocks’ expect a higher return for the same reason. The price isn’t as high compared to the cash flows as these stocks are considered riskier. A higher chance of failure because they are newer or smaller companies and more subject to failure so investors demand higher returns.
‘Market/stocks with higher beta’ - stocks that have higher volatility compared to the market expect a higher return as there is more risk being taken.
All of the above is a logical approach towards investing, a risk framework. Investors expect higher returns as some way they are taking more risk in some way or another.
The problem for Cliff was that he was more interested in building on the current work that showed a new pattern which is that stocks that have started to trend in a certain way seemed to consistently follow that trend in a way that couldn’t be explained logically. Not a random movement, a statistically significant observation.
Cliff had to approve his PhD thesis on this new trend which was later to be more commonly known as ‘momentum’ to his hero and Professor, Eugene Fama. He was understandably extremely sheepish about asking to explore this possible factor for investment returns in more depth. How often do you have to ask permission to research a field that has the potential to undermine the work of your Professor? We can rationalise why investors would want higher returns for more risk but they’d expect higher returns because things have started moving in a certain way.... that doesn’t follow. When requesting to explore this further, would Fama try to downplay his theories or perhaps try and shut it down entirely? Would it compromise the relationship he had built?
Cliff said in an interview it turns out that he needn’t have been worried. When he broke the news to his Professor, Fama without missing a beat had turned and said:
“If it’s in the data, write the paper.”
While we’ll never know exactly what Fama may have been thinking at the time. How many of us would react in a way as intellectually honest as that? How often do we accept views on investment or life which have the ability the undermine what we not only believe but also have invested a lot of ourselves into? To what extent does thinking that way hinder our ability to see true reality and what advantages can it give us to be able to think in a way which allows us to be open to how things are, regardless of the consequences. Even to this day, momentum as a factor still causes Fama the biggest problems:
“Momentum in my view is the biggest embarrassment for efficient markets....I’m hoping it goes away.” - Eugene Fama, 2015
It’s there - you just can’t see it
‘Go’ is an ancient strategy game hugely popular in South Asia. It’s a game that originated in China and is believed to be 3,000 years old. Known as the oldest game in the world that is still being played in the present day with tens of millions playing it annually. Everyone from student to master will have tried different techniques and like many games, strategies will have passed down through the generations.
Despite its ancient origins, it is incredibly complex. To put this into context, there are 10^170 possible board configurations. If you can’t quite imagine a figure like that. It’s because there are more movements on the board than there are atoms in the known universe.
The complexity and also the thousands of years of human history playing the game positioned it as an intriguing target for Google’s ‘DeepMind’ project. The aim setup was to use machine learning to see if despite how impossibly complex the game is; if it could have an algorithm set up to learn the game itself could end up beating the very best human minds of modern-day.
Across various games, in March 2016 Alpha Go convincingly beat the world’s best player. Reportedly, Chinese State Television turned off the cameras partway through the game when it became clear that Alpha Go was going to win. The American-backed AI had just consistently beaten their best player who was a byproduct of billions of human players and strategies developed over our history. It had done so by inventing moves that had never been seen before in the thousands of years of humans playing the game.
Eric Schmidt, former CEO at Google remarked from the back of Alpha Go’s success that there is probably a more profound conclusion to be reached from this which is beyond the simple outcome that AI is more intelligent than humans. In an interview in January 2022:
“Does AI perceive things that are different than we perceive... and if so, what happens.”
“How is it in a game that is mature as Chess or Go, that we (AlphaGo) can create a new strategy for a game that has been played for thousands of years? One possibility is that it was always there for humans to discover they just couldn’t see it. Another possibility is the computer discovered a new truth. That we as humans can’t fully perceive.”
The theory is, that perhaps there are some moves that are so unnatural to the way humans think and have evolved to behave that regardless of the number of games played, we would never have seen. If it is true that a thousand monkeys typing on a thousand typewriters for infinity creates the full works of Shakespeare. We have to acknowledge that despite having infinity, there are some things that are limited by the fact - they are just monkeys.
Making peace with the unknown
When we make investment choices and choices in life. We have to accept there will always be things we can’t see. There will always be blind spots, incorrect assumptions and mistakes in hindsight. To be a good investor requires having sufficient understanding to not get distracted by investment fads but also to have enough humility to navigate an ever-adapting world.
If you are putting together an investment strategy that will shape you and your family’s future, you want to give yourself the best chance of success. Part of that is making peace with the unknown but knowing like Fama, it is far better to let the data guide you beyond your own personal opinions. Here is a summary of that investment data into core principles:
Around 80% of active managers fail to outperform their benchmarks after adjusting for costs.
When the data is extended over larger time periods, these figures get worse.
Diversifying is the best way we can increase the chance of positive returns.
Stock returns are highly skewed. The market return is driven by a small handful of extreme winners.
Diversified shares have been proven to drive higher long-term returns than diversified bonds but are more volatile.
The fact that we can never see everything with the financial markets has no bearing on making good investment decisions. Often the biggest mistake one can make is constantly changing strategy looking for the ‘next best thing.’
Momentum may have caused issues for Fama’s theory - but it didn’t stop him from creating the most accurate model of security pricing we have to date. Part of his enduring success as an academic I believe is that intellectual honesty. To endeavour to try and see things for how they are, despite the cost. Even the data I have put in above should not be expected to stay fixed forever. SEE HERE. The problem occurs when we focus on a degree of uncertainty and extend that into narratives that at all perceptions and little reality:
Central banks are printing - “Put it all in gold!”
Stocks are going down - “They’re going to crash to zero”
Fund manager beats the market - “Passive investing’s a waste of time.”
When we get too fixed in our views that perception is our reality and we completely ignore the evidence. Even if you are a Nobel Prize Winner or Go Grandmaster you can often find - reality never cared about your perceptions.
