BrooklynInvest wrote: ↑
Sat Jan 13, 2018 1:14 pm
Sorry if this is naive - what's the difference between factor investing and, admittedly sophisticated, backtesting? A dumb example -
Let's say that over the last 30 years, stocks in my (indexed) portfolio at the very beginning of the alphabet - Apple - have performed better than stocks at the end of the alphabet - Xerox. Is "alphabet investing" a factor?
If so I'm opening a hedge fund to some sucker . . . . um, pioneering investors!
Over any given period there has to be a group of outperformers and underperforms linked by some commonality. Value over growth, or the reverse, small over large, dividend growers versus dividend payers yada yada.
Like the old "Dogs of the Dow" - are we implying structural causality and therefore opportunity to mere long term coincidence?
It's hard to get away from backtesting because we don't have the patience to wait for investing experiments.
Speaking as someone who is a skeptic, there is, nevertheless, a big difference between factor investing and your "alphabet" investing. The idea behind factors is to discover large groups of stocks that behave similarly to each other... and different from the rest. In the days of the three-factor Fama-French model, we would have said: when we know that Alphabet is a stock, we know 70% of all that can be known about it. It is not some completely unique thing, it's just 70% "it's a stock" and 30% "completely random behavior we can't predict, due to the efficient market having squeezed everything predictable out of it."
By exploring for factors, they tried to find general, common... well... factors that could be used to explain or predict some of that 30%. So instead of saying, one extreme, "Alphabet is a stock and that's all we can say about it," or, other extreme, "Alphabet is everything in its annual report and ten thousand other details..." we can say "Alphabet is +1.29 market, -0.46 size, -0.92 value. THAT tells us 90% of all that can be known about it, and the other 10% is completely random."
Once we have our factors (if it's all true!) we see the world in terms of factors, and stop trying to pick individual stocks and instead start trying to pick some mix of the three factors.
As to where it fits--again, if it's all true--it is an important step in the "prescientific" stage, the stage in which investigators find useful classifications that have some predictive value. Oh, it's in this column of the periodic table, therefore it is probably not going to react with anything; it's over here, so it's a metal, so it will probably conduct electricity. It's not quite being able to solve the quantum wave equations for the atom, but it's more than saying "so much earth, so much air, so much fire, it burns because it's full of the fire nature."
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.