The rising tide

A few days ago, I had the opportunity to judge the 'NJ Factor Investing Olympiad 2024'. The final round had eight teams, mostly from well-known business schools, and the eventual winner was the team from IIM-A. You can learn more about this contest from www.njfio.com. Briefly, factor investing is an approach to investing that involves choosing securities based on certain attributes or factors that are thought to influence their returns. These factors may encompass traits like value, size, momentum, quality, and volatility. This sounds obvious to any seasoned investor, but the important distinction here is that subjective judgement plays no role in stock selection.

Factor investing is a somewhat fancy name for rule-based, algorithmic investing. The job of the investor is to formulate the rules based on their own understanding and research. They can try and backtest alternatives, but there is no room for subjective judgement once the rules are formalised. In theory, anyway. In this contest, even though there was only one winner eventually, all the finalists had created factor sets that generated good investing performance when backtested over the last fifteen years or so. Given that all the contestants were young students, the ideation and the process that went into working were impressive.

Still, as always with any contest or simulation, the important question is whether the plant growing well in a flower pot will also flourish in the jungle. I would say that the biggest factor that changes between a backtest is the psychology of the investor. When your actual money and future are at stake, things are different. The emotional and mental challenges of putting real money on the line can be a far cry from the controlled environment of a backtest or simulation. When an investor's own capital is at stake, the pressure to perform can be immense. The fear of losing money, the temptation to deviate from a strategy during market volatility, and the difficulty of maintaining discipline in the face of uncertainty can all take a toll on even the most well-designed factor investing strategies.

I'm not talking specifically about this contest nor commenting on the countless investors who are presenting evidence of great success on social media. We have had years and years of good equity markets and a strongly growing economy. The reality is that in such a time, there are a lot of strategies that do well. You have to look at the performance of various mutual funds to see evidence of this. In fact, an investor has to be actively foolish to do badly. It's tempting to say that investors have become better. The real answer is that the markets have been doing well for a long time now. There's that old saying in the markets, 'A rising tide lifts all boats'. The real test comes when the tide starts receding.

Experienced investors distinguish themselves from those who have simply spent time in the markets by possessing a keen awareness that market trends, no matter how strong they appear, are ultimately temporary. Their extensive experience and recollection of previous market cycles serve as a constant reminder that what goes up must come down, and vice versa. This understanding allows them to navigate the ever-changing market landscape with a level-headed approach.

However, the key to investing success lies not solely in understanding the market cycle itself but rather in managing one's own psychological response to it. As the market progresses through its various stages, investors undergo a corresponding psychological cycle. The ability to recognise and effectively manage these personal psychological phases ultimately determines an investor's financial success and whether they achieve their long-term financial objectives. In essence, mastering one's own emotional response to market fluctuations is just as crucial as comprehending the market and the factors that control it.

Also read: Understand and control