To be great, you must first learn to be good

Cliff Asness on Bloomberg TV yesterday:

“I used to think being great at investing long-term was about genius,” Asness said.

“Genius is still good, but more and more I think it’s about doing something reasonable, that makes sense, and then sticking to it with incredible fortitude through the tough times.”

We discuss this concept with clients of our firm all the time because it is very important. If you want to be great, you must first learn to be good. Being good means accepting that a strategy that outperforms long-term must have some shorter-term periods during which it is merely average and some periods where it is below average.

The other alternative is hopping into whichever strategy looks best at the moment, which you will most surely do closer to the peak of that strategy’s run, as mean reversion kicks in and the wheel in the sky turns another revolution. This is a sure way to give away your money to the house, again and again.

Investors attempting to be the best must be willing to be the worst. We don’t believe this approach makes any sense at all. Howard Marks agrees. In a classic memo, Marks refers to a statement once made by a fund manager that found himself trailing the S&P 500 by 1840 basis points in a given year. The manager explains to his shareholders that if you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%, too.

Surely, this kind of “swing for the fences” approach is more disastrous than it is promising. Marks responds with another anecdote, about a much wiser manager:

As an alternative, I would like to cite the approach of a major mid-West pension plan whose director I spoke with last month. The return on the plan’s equities over the last fourteen years, under the direction of this man and his predecessors, has been way ahead of the S&P 500. He shared with me what he considered the key:

“We have never had a year below the 47th percentile over that period or, until 1990, above the 27th percentile. As a result, we are in the fourth percentile for the fourteen year period as a whole.”

I feel strongly that attempting to achieve a superior long term record by stringing together a run of top-decile years is unlikely to succeed. Rather, striving to do a little better than average every year — and through discipline to have highly superior relative results in bad times — is:

– less likely to produce extreme volatility,
– less likely to produce huge losses which can’t be recouped and, most importantly,
– more likely to work (given the fact that all of us are only human).

That last bit, about being human, is why optimized alpha strategies are nearly impossible to live with. The very biggest returns accrue to those who had been willing to accept tremendous short-term drawdowns and volatility along the way. On paper, this is a bloodless backtest. In reality, this is the stuff of late night agita, back pain and binge-eating.

And entirely unnecessary.

The manager Marks cites is winning by not losing big. He’s not in the top 5% of his peers in any given year, but he’s in the top 5% long-term because the hotshots at the top eventually get their blocks knocked off. Imagine Icarus, flying directly into the sun with wax wings.

Becoming a great investor by being a merely good investor is a smarter approach. You win by steering with a steady hand, watching the car wrecks and pileups on all sides of the highway recede in the rear view mirror. And then, before you know it, there are very few drivers left ahead of you.

Asness’s firm, AQR, studied Warren Buffett’s historical performance at Berkshire Hathaway – the epitome of investing fortitude.

“Of course they found he was fantastic — but not quite as fantastic. His track record was phenomenal… but human phenomenal,” Asness said. “What was beyond human was him sticking with it for 35 years and rarely, if ever, really retreating from it.”

“That was a nice little lesson that you have to be good, even very good, but sticking with it and not getting distracted is much more the job,” Asness said.

Can you stick with an investing strategy even when your peers say “it’s dead” or the media decides “it’s not going to work going forward”? Can you maintain your cool when others seem to be pulling golden nuggets out of thin air doing something else – daytrading, investing in startups, concentrating positions in biotech, selling out-of-the-money puts, etc?

Your ability to attain the only returns that count – the long-term returns – will be determined by your answer to this question.