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How Do You Know If Your Investment Strategy Has Stopped Working?

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Over the last three calendar years, Global stocks (MSCI All Country World Index - ACWI) have returned a meager 3.7% annualized leading some to question their investment approach. Large market moves up are obviously fun, and even big moves down are often easier to ride out (at least you can see something happening) than a sideways markets. It’s extended periods of low returns which test patience and one’s ability to stick with a strategy and let it work over time. Three Years Returns ACWI.png

These periods can be frustrating, causing investors to wrestle with questions like: am I doing the right things to succeed? Is there somewhere else I should be focusing? Are there changes I should make? The pain of patience triggers the question: is my strategy broken?

In his fantastic biography, legendary mathematician, successful gambler, and hedge fund manager, Ed Thorp reveals how he answers this question.

In 1960, fresh off the development of his “Ten-Count” system for blackjack, Thorp persuaded his reluctant wife to make a detour to Las Vegas on their family trip from Boston to California in order to test the method. The system works by counting the number of ten cards left in the deck—the higher percentage left in the deck, the greater the odds for the player (and lower the odds for the casino)—and then increasing (decreasing) the bet amount as the odds increase (decrease). With a bankroll worth about $200 ($1600 in today’s dollars), Thorp promptly lost $32 ($250 today) with his new system before his wife decided they were done playing.

So, what did this experience do to his confidence in the “Ten-Count” system? Thorp writes:

“The $32 loss was well within the range of possible outcomes predicted by my theory, so it didn’t lead me to doubt my results.”

In fact, he went on to use the system and others developed later to take enough money from the Vegas casinos to necessitate playing with a disguise and to nearly getting himself, his wife, their friends killed in an car “accident” when his accelerator suddenly jammed on the highway leaving Las Vegas. He later used the same framework as a hedge fund manager to assess whether a strategy had stopped working, or if it was simply an unlucky, if very possible, result.

He sums it up the experience as follows:

For the second time, the Ten-Count System had shown moderately heavy losses mixed with “lucky” streaks of the most dazzling brilliance. I learned later that this was a characteristic of a random series of favorable bets. And I would see it again and again in real life in both the gambling and the investment worlds.

So, our question is, where do the returns over the last three years fall in the “range of possible outcomes?”

Again, over the last three years (2014-2016) the return on global stocks was 3.7% annualized. Where does this stack up? How unlikely (or not) is this?

Since 1991, which is as much data as available on the All Country World Index, the worst three-year return on the index was a loss of 18% (three years ending March of ’03) and the best period was a gain of 25% (three years ending March '06). 3.7% falls in the 30th percentile (see chart below), or something you would expect every 3.5 years, or so.

Not unusual at all. 

ACWI Histogram.png

 

Periods of low returns, while not a lot of fun to sit through, should be expected. As Ed Thorp remarked about his approach to blackjack (and later investing), if our performance falls within the range of possible outcomes, it shouldn't cause us to doubt our results, or our strategy.

Click here for disclosures regarding information contained in blog postings.
Cordant, Inc. is not affiliated or associated with, or endorsed by, Intel.

Published on March 29, 2017

Isaac Presley, CFA

Isaac Presley, CFA

Isaac Presley is Director of Investments for Cordant, a wealth management firm serving current and former Intel employees. To learn more, you can read Isaac's full bio.

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