When You Eat Matters More Than What You Eat.

Nassim Taleb has an interesting story from Antifragile that correlates uniquely to investing strategies.  The passage is as follows:

“And one blatant denial of convexity bias is the theory about the benefits of the so-called Cretan (or Mediterranean) diet that triggered a change in the eating habits of the U.S enlightened class, away from steak and potatoes in favor of grilled fish with salad and feta cheese.  It happened as follows.  Someone looked at the longevity of Cretans, cataloged what they ate, then inferred — naively — that they lived longer because of the types of food they consumed.  It could be true, but the second-order effect (the variation of intake) could be dominant, something that went unnoticed by mechanistic researchers.  Indeed, it took a while to notice the following: the Greek orthodox church has, depending on the severity of the local culture, almost two hundred days of fasting per year; and these are harrowing fasts.”

Nassim Taleb, AntiFragile.

The key of this story centers around determining what truly causes the Cretans’ good health.  Is it the ingredients of their diet, i.e. the types of food they eat, or is it the frequency of their diet?  Taleb believes the diet may be good for you, but the real benefit to your health lies in the frequency of the meals.   Dietary research supports this position as well.   

Application to Investing

With that in mind, think about the following type of statement that is very common in investment research:

“We created a portfolio consisting of the top 20% of US equities ranked by XXXXX over the last 12 months with monthly rebalancing. We then compared it to the US stock market. We found that the XXXXX portfolio outperformed the stock market since 1989.”

See the comparison?

The XXXXX is something like, volatility, or size, or beta, or momentum or value, etc.  Here’s the thing though.  It could be ranked alphabetically by third letter in the company name, or by the length of the CEO’s nose hair.  Or any nonsensical ranking method you can imagine.  The ranking method doesn’t matter.  What matters is monthly rebalancing vs the market index — which effectively rebalances far, far less frequently. ¹   Monthly rebalancing, the “frequency”, increases the expected geometric return (all that matters) and reduces the overall volatility of the portfolio. Over the long run, monthly rebalancing alone will always outperform the S&P500.

So lets re-write Nassims Taleb’s quote in terms of investing.

And one blatant denial of repetition bias is the theory about the benefits of the so-called factor (or smart beta) strategies that triggered a change in the investing habits of the U.S enlightened class.  It happened as follows.  Someone looked at some academic studies, cataloged different strategies, then inferred — naively — that they beat the market because of the “factors” they favored.  It could be true, but the second-order effect (the repetition of rebalancing) could be dominant, something that went unnoticed by mechanistic researchers.  Indeed, it took a while to notice the following: the studies will, depending on the strategy being analyzed, rebalance yearly or even monthly, usually across hundreds of investments, improving the geometric returns.

Breaking the Market, His Blog.

This style of investment research doesn’t identify types of stocks that out-perform, they identify trading strategies that outperform.  It’s the diet vs. frequency of food intake error Taleb identified all over again.  And no one in the investment world sees it. 

But you should now.   

1- Astute observers will recognize that Taleb is advocating for random, less uniform application of the ingredients for diet, and I am stating the ingredients needs be be uniformly rebalanced for investing. Seemingly opposites. However, Taleb’s convexity bias in diet is upwards. In investing, the volatility drag has a downward convexity bias. Therefore we would prefer less randomness. Still the same concept, just with different directions in convexity bias.