When we make decisions in life, the outcome normally provides direct feedback on the quality of the decision. For example, when choosing one apple over another because of a blemish turns out to be a good decision because the next customer found the worm ! However, in some domains– like the stock market – the feedback is trickier. In the short-term, the outcome is only a loose signal of decision quality. Engineers refer to such a system as having a low signal to noise ratio.
When the feedback is very noisy, it is more difficult to use the feedback for learning. One cannot necessarily extrapolate from a single case whether your decision was good or bad. You cannot tell on the next day whether your investment was a sound one. But humans have a tendency to create a strong connection between the result and the quality of the decision. When picking apples, this is a rational approach. When picking stocks, not so much. This is so because uncertainty plays a larger role in the market.
Where markets are concerned, a quantitative approach can be useful. By looking at many similar examples and learning from all of them, one can make a more general deduction. It looks, on average, like the market rewards companies with a low price to book ratio, more than it does companies with a high price to book ratio. In this way, your investment decisions stop being about being wrong or right on any particular day, but about calibrating among all the shades of grey.
A great decision can have a good or a bad outcome. The thing that makes a decision great is not its outcome, but whether it is the result of a good process.
Prescient has a very strong focus on process because, by looking at the information in an honest, less biased way, we are more open to calibrating our strategies. Our strategies improve the more objective we are, and in the long run, the most accurate strategies win.
Factor investing is in essence the application of broad investment ideas in a quantitative manner. Examples include value, momentum, size, quality and low volatility. The premise behind value investing is to choose between two comparable assets the one with the lower price. Momentum investing posits that stocks with positive price momentum will keep performing better than their peers. The size premium aims to reward investors for investing in smaller companies. Intuitively it also makes sense that high-quality stocks with more stable earnings, higher profit margins and stronger balance sheets outperform their low-quality peers over time. The low volatility factor aims to reward investors for investments that exhibit lower levels of stock price volatility over time.
Prescient’s processes prevent us from getting caught up in the day-to-day uncertainty of the market – we look through the noise for the signal. When others zig and zag, we stay in formation.
With inspiration drawn from Annie Duke’s book: Thinking in Bets