12 Jul Takeaways From Gestaltu’s “All Strategies Blow Up”

On equity risk premium

Without occasional highly unpleasant periods, investors could not expect to earn any excess returns over safe cash. To see why, consider the excess returns to stocks versus cash or bonds. An equity index, like the ubiquitous S&P 500, is a simple quantitative strategy which systematically holds qualifying stocks in proportion to their respective market capitalizations.

But stock markets have historically BLOWN UP about every 5 to 7 years in the form of explosive bear markets. In return, equity investors are compensated for bearing this risk; this compensation is the called the ‘equity risk premium’. Many investors, who are not steadfastly convinced of the persistence of the equity risk premium, capitulate to fear and sell their stocks at the depths of bear markets.

These people are the equity risk premium. They donate capital to those who are long-term true believers that equities will outperform.

We can expect the equity premium to deliver a persistent premium through time, so long as equity markets are expected to inflict regular BLOW UPs, which shake out weak hands.

On value and momentum premium

Investors who attempt to take advantage of alternative sources of risk and return, such as value or momentum premia, should not be under the misapprehension that they have successfully avoided risk. If that were true, they would have also successfully avoided excess return! Rather, investors in these alternative premia have simply substituted one risk for another.

One risk that both value and momentum premia exhibit is the risk of under-performing the assets being ‘timed’ for extended periods of time.

On investing discipline

Investors become infected with the suspicion that the factors they are harvesting are somehow ‘broken’, or no longer exist. This fear and doubt compels many investors to abandon these strategies toward the tail end of under-performing periods, leaving money on the table for more disciplined investors to reap. If these unpleasant periods did not exist, everyone would follow the strategy and no one would abandon it; thus no one would leave behind any excess returns!

All investment strategies that are expected to deliver long-term excess returns must be expected to very seriously test your ReSolve on occasion.

Article: All Strategies “Blow Up”