The Failure Of Historical Data Advantages

In past episodes of Mr. Tako Escapes, I’ve written rather incessantly about the difficulty of trying to predict the future.  Even though it would be exceedingly handy to predict future stock market movements, most humans have no ability to predict the future.

Despite this, many people try — They gamble hard-earned money on the speculative investments in the belief that the investment will become “The Next Big Thing”.  Sometimes they win, and sometimes they lose.

Today I’d like to take a look at a variant of this future predicting insanity — a method of “divination” whereby the soothsayer uses data from the past to predict future movements of the stock market or individual stocks.

Much like numerologists, these individual investors hunt for “patterns” in historical data.  Patterns that supposedly provide an ‘edge’ in the hunt for superior investing returns.

Is there any real advantage to be found by using this method?  Let’s find out…

Does A Data Advantage Exist?

We live in a world of data.  A world with billions of bytes of data freely available to anyone with a computer and an internet connection to exploit.  This data, which is widely available for stocks over an entire century is historical.  (By very definition all data is historical).

Never mind the fact the SEC has been forcing the phrase, “Past performance is no guarantee of future results” down our collective throats for decades, people are still trying to find patterns in historical metrics that predict future results.

There are now millions of individuals and organizations hunting through historical stock data in search of some “analytical edge” that will provide above average investing returns.  Anyone with a computer and an internet connection can do this, which means millions of humans ARE doing it.

Much like a infinite number of monkey’s typing away on typewriters, one monkey will eventually produce the investing equivalent of a Shakespearean play — an ‘edge’ that creates superior investing returns (called ‘alpha’ in the investing world).

Yes it’s true — A few rare monkeys investors have been able pull pure gold nuggets from historical stock market data.  They found ways to generate monstrous out-performance.  It’s rare, but it does actually happen…

Real World Examples

While it might sound imaginative, finding an advantage and exploiting it is exactly what Joel Greenblatt did.  Through his firm Gotham Capital, he earned average annual returns of 30+% by investing in “special situations”.

Back in the early 1980’s, Greenblatt realized (before anyone else) that stock spin-offs, mergers, and a few other “unique situations” produced superior investing returns.  So, he exploited that advantage to his fullest.  From 1984 to 1995 his firm generated incredible returns, and then closed shop in 1995.  He returned all capital to investors.  A few years later he published a book on his special situations strategy — called You Can Be A Stock Market Genius.

Well played Mr. Greenblatt, well played!

Why would anyone make a ridiculous amounts of money and then suddenly stop?  Invariably Greenblatt exploited the data advantage as long as he could.  When it finally stopped working he decided to exploit that advantage another way (by publishing a book and selling the idea to the public).

Greenblatt isn’t alone in stumbling upon a historical data advantage — There have been a few others.   Ben Graham, the father of value investing, most famously found a data advantage in the form of ‘net nets’ — stocks trading below the book value of their net current assets.  Graham exploited this advantage in his partnership from 1936 to 1956, averaging 20% annual returns.  Graham also wrote a few books, one of which I recommend to readers.

After learning the ‘net net’ strategy at the feet of Ben Graham, Warren Buffett also went on to exploit this ‘net net’ strategy.  In the early days of his investing career, Buffett utilized the data advantage to produce annual returns of 24.5% from 1957 to 1969.

At the time, Buffett knew his advantage was evaporating — he wrote the following in 1967 (near the end of his partnership):

Such statistical bargains have tended to disappear over the years… When the game is no longer being played your way, it is only human to say the new approach is all wrong, bound to lead to trouble, etc. I have been scornful of such behavior by others in the past. I have also seen the penalties incurred by those who evaluate conditions as they were – not as they are. Essentially I am out of step with present conditions.

Clearly he knew the game was almost over.  He had quite a run.  Of course, Buffett’s career wasn’t completely over when his partnership was closed — One of his biggest investing ‘mistakes’ became the Berkshire Hathaway that we know and love today.

My point being — Historical data advantages do exist in the real world, but are quite rare.  The time scope under which they can be exploited is also very limited.

Simply put, average investors like you or I are extremely unlikely to stumble upon a historical data advantage that works.

While it is still possible to exploit the rare spin-off or net-net investment, profiting from these investments is far more difficult today than it used to be.

Why?

Because millions of other monkeys in front of keyboards investors are also looking to exploit these highly publicized ideas… thereby quickly arbitraging away any advantage that may have existed.

As I wrote about in my post on special situations, good ‘deals’ are often arbitraged away in a matter of hours now.

What About Other Strategies?

Over the years I’ve done my best to throw cold water on these so called “historical data advantages” sold to the public.  While many stock picking or investing strategies may have worked at one time, any investor who takes a long-hard-look should be able to see the out-performance doesn’t really exist anymore.

Here’s a few of the more popular investing strategies I’ve posted about over the years:

• Low Beta Investing – Low Beta Investing: The Anomaly of Lower Risk And Greater Returns
• Greenblatt style “special situations – Extra Credit: Investing In Special Situations
• Defensive stock pivoting – Defensive Stocks: A Investing Strategy For Mr. Market’s Bad Mood
• Utility stocks (another form of defensive investing) – Utility Stocks: Treasure Or Trash?
• Investing in stocks with large share buybacks – The Dark Side Of Share Buybacks
• Net-Nets and low book value investing – Is Book Value Investing Still Relevant?
• Master Limited Partnerships – Should I Be Investing In Master Limited Partnerships?
• Following Insider Trading – Investing Hacks: Should You Follow Insider Trades?
• Investing in outperforming industries – The Loser Industries

That’s quite a few posts!  Most of these posts dissect some kind of historical data strategy that is still commonly promoted by books, investing gurus, or the internet.  If you’re new to my blog, it should keep you reading for quite awhile!

In my experience, most of these strategies fail to outperform broadly.  (Certain individual stocks might still work using these strategies.)

And these are only a few examples!  There’s tons of these ‘historical data’ type strategies I haven’t written about!

Smart investors would be well served to always seek out dissenting data before following in any strategy that’s based on “historical data”. There’s almost always problems to be found — either in newer data, or in real-world implementation of that strategy.

Closing Thoughts

To bring this post to a close, I think another quote from Warren Buffett might be appropriate:

“If past history was all that is needed to play the game of money, the richest people would be librarians.”

It’s so true — I’ve met a good number of librarians in my life, and NONE have been billionaires.  Buffett is not wrong in this regard; Knowing your stock market history is not a predictor of future returns.

At least not a very good predictor.

Over the years, my own research has confirmed this:  Strategies based upon historical data aren’t the path to wealth and riches you see them touted as.  Most of the time they only match the market or under-perform it.

A better solution for the average investor might be to become a Farmer rather than a Hunter, and exploit the one real advantage Mr. Market can’t arbitrage away — Your ability to live frugally and save a larger percentage of your income.

Good luck investing!

[Image Credit: Flickr1, Flickr2]