Mind Over Model

In the world of investment management, there has been much discussion about multi-factor models.

But many of these models, which are often marketed as "smart beta strategies", also have limitations, which many investors may not be aware of.

Let's begin by looking at a simple example of a model: a weather forecast.

A meteorologist uses current and past weather data to make a number of guesses about what the future weather will be. You, in turn, may rely on this model to determine whether you should take your umbrella when you leave for work in the morning.

However, as anyone who has been caught in rainy weather without an umbrella knows, reality frequently differs from the predictions of a model. In other words, whilst models can be useful for gaining insights that can help us make good decisions, they are inherently incomplete simplifications of reality.

In investment management, models are used to gain insights that can help inform investment decisions.

Financial researchers frequently look for new models to help answer questions like, “What drives returns?”

These models are often touted as being complex and sophisticated, inciting debates about who has a better investment model.

Meanwhile, investors who are evaluating investment strategies can benefit from understanding that the reality of markets - just like the weather - cannot be fully explained by any meteorological model.

Mind the Judgment Gap

Just like with weather forecasts, investment models rely on different inputs. Instead of things like barometric pressure or wind conditions, investment models may look at variables like the expected return or volatility of different stocks.

Using these sorts of inputs, one type of investment model may recommend an “optimal” mix of stocks based on how these characteristics are expected to interact with one another over time. Investors should be cautious though. The saying “garbage in, garbage out” applies to investment models too!

In other words, a model’s output can only be as good as its input, and therefore poor assumptions can lead to poor recommendations.

Indeed, even with sound underlying assumptions, an investor who places too much faith in inherently imprecise inputs can still be exposed to extreme outcomes.

Given these constraints, I believe bringing financial research to life requires presence of mind and an acute awareness of the limitations involved models, in order to identify when and how it is appropriate to apply a particular model.

No model is a perfect representation of reality.

Instead of asking, “Is this model true or false?” (to which the answer is always false), it is better to ask, “How does this model help me better understand the world?” and, “In what ways can the model be wrong?”

So what is an investor to do with this knowledge?

Before investing, it is important to understand an investment manager's ability to test and implement model-based ideas into real-world applications.

This step requires judgment on behalf of the manager, and an investor who hires a manager to bridge this judgment gap is placing a great deal of trust in that manager.

The transparency offered by some approaches, such as traditional index funds, requires a low level of trust on behalf of investors because the model is often quite simple, and it is easy to evaluate whether they have matched the return of an index. The downside to this level of mechanical transparency is that it may sacrifice the possibility for higher returns, as matching the index is prioritized over everything else.

For more opaque and complex approaches, like many active strategies, a higher level of trust is required. Investors should look to understand how these managers use models and question how to evaluate the effectiveness of their implementation.

Indeed, rigorous attention must be paid to how any such strategy is implemented. To quote Nobel laureate Robert Merton, the successful use of a model is “10% inspiration and 90% perspiration.”

In other words, having a good idea is just the beginning.

Most of the effort required to make an idea successful is in effectively implementing that idea and making it work.

In the end, there is a difference between blindly following a model and using it judiciously to guide your decisions.

As investors, cutting through the noise around the “latest and greatest” investment products and identifying an approach that employs sound judgment and thoughtful implementation may increase the probability of having a positive investment experience.

Amyr Rocha Lima, CFP® is a financial planner who specialises in working with successful professionals age 50+ to help them reduce taxes, invest smarter and retire on their terms.

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