The Soft Science of Markets: Look Past Specifics to Find the Essence

• Posted by derek
• on September 16th, 2010

Financial markets are not a hard science like physics or chemistry. Witness the outsized thrashing when a company misses earnings estimates by .01.  Why?  It’s not because of that penny, it’s because the company failed to deliver as expected, and if management can’t offer a tangible reason why this is a one-time failure the cockroach theory comes into play.

I thought of the folly of precision in markets when reading this post from CXO Advisory.  In searching for the perfect inputs to a trend following method, the reader may miss the essence…using ANY intermediate-term smoothing mechanism allows an investor to sidestep long bear markets.

The topic of using a moving average to guide asset allocation took flight with the publication of Meb Faber’s 2006 paper “A Quantitative Approach to Tactical Asset Allocation”.  He settled on a 10 month SMA for his study…buy when above, go to cash when below.  It has become popular in the active manager community(myself included), but it’s not a holy grail to easy riches…it’s a risk management tool.  Whether it’s a 6 month or a 12 month or a 222 day or whatever, Faber’s point is that the most damaging environments occur when prices persist below where they’ve been in recent months.

When applying numbers to markets, remember the words of Carveth Read(later attributed to Keynes)…”‘It is better to be vaguely right than exactly wrong”.  If one’s goal is to eliminate risk rather than manage it, the lesson to remember with any backtest is garbage in, garbage out.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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