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Adaptive Value Investing for the Long-Term Investor

September 13, 2013 | About:
Andrew Lo is the Charles E. and Susan T. Harris professor, a professor of finance, and the director of the laboratory for financial engineering at the MIT Sloan School of Management and one of the most prolific and influential researchers of market and economic behavior.

Over the years, Lo has talked complex subjects such as options, financial engineering and risk management with groundbreaking results. He has also written two books on technical analysis that no one has ever read but everyone probably, especially practitioners of the charting and statistical methodologies, should.

Lo is one of the most prolific and influential market and economics researchers of the past several decades.

He has developed a theory to challenge the efficient market theory that is still taught in many business schools but has been proven fatally wrong in practice for some time now. Rather than draw on just the pure rational thought and math of traditional economic research, Lo brings in theories of evolution, biology and neuroscience to develop what he calls the adaptive market hypothesis.

The theory reaches five basic conclusions that have important implications for investors and is an interesting and worthwhile exercise to look at these through the lenses of a value investor.

The Risk-Reward Relationship

The first conclusion, or principle, of the adaptive market hypothesis is the relationship between risk and reward is not stable and will change over time based in the condition of the market. This is something that has already been discovered by value investors. As market and economic conditions change the level of investment will naturally fluctuate based solely on the number of opportunities available that are safe and cheap.

Chasing beta in the form of momentum stocks can be fairly low-risk high-reward activity when markets are rising consistently but is dangerous and financially fatal in markets that are drifting sideways or trending down. No manner how many fancy equations you use to try and determine the risk and reward relationship, the fact that humans with natural biases, desires and fears are market participants means the relationship will change constantly over time.

As value investors it is our job to find ways to exploit that changing relationship by focusing on the risk first with the reward as a secondary factor.

The Presence of Arbitrage and Anomaly Opportunities

The second conclusion is that arbitrage opportunities or anomalies are always going to be present. If they were not then there would be no point in research or price discovery and markets would pretty much cease to function. While value investing is not exactly arbitrage it is along with the small cap effect and momentum one of the longest running anomalies of all time for the simple reason that the large funds cannot play in our sandbox.

Other arbitrage opportunities and anomalies are usually pushed out by the ecological cycle of the market when too much money comes into too small a space and the edge disappears. That is almost impossible in deep value stocks. With the exception of the aftermath of a meltdown or crash it is simply impossible to put tens of hundreds of billions of dollars to work in small cap deep value.

Strategies Only Work Some of the Time

The third principle is that various strategies — whether fundamental, technical, statistical or fundamental will work some of the time but not all of the time. Anyone who was a value investor in the 1990s knows that while basically true, there is a small hole in this part of the theory. Although we lagged the indexes, tech stocks and day traders are performance in absolute terms was actually quite satisfactory.

The underperformance as it was was more due to the excess returns earned by the cycle of greed and euphoria that held the markets in its grasp than a failure of the principles of deep value investing. Nonetheless we will underperform at various points in the market cycle.

Learn to be Innovative

Here, we switch the order of the conclusions around. The best way for an investor to earn decent long-term returns is to be innovative. Market cycles and the factors influencing the market will always be changing so you have to adjust the way you look at the market and what you buy in order to earn solid long term returns.

Here deep value investing excels as it is to a very large degree self-adapting. There is a forced timing mechanism that reduces and increase market exposure as the opportunities are created and eliminated. The pockets of value are always shifting in the market due to others fears and expectations. In the aftermath of the S&L crisis in the 1990s it was banks. During the Clinton-era attempts to reform health care, it drifted toward drug and medical stocks. In 2003 it was technology stocks.

In 2008, it was banks once again and real estate-related concerns. Today, the deepest pockets of value appear to be in material, energy and consumer electronics. Deep value automatically adapts based on the actions of other market participants and keeps you evolving with the market cycle.

How to Survive in the Woods... err... Long-Term as an Investor

The last and most important principle is that the primary job of a long-term investor is to survive to reach the long term. By focusing on margin of safety first and returns second, the deep-value business-like approach to the markets protects you from the risk of severe permanent loss of capital due to excessive risk taking or a simple failure to evolve as an investor.

While nothing can eliminate quotation loss due to market fluctuations, an emphasis on business value rather than price movements can reduce the risk of an investment portfolio blowing up or leading to you being carried out of the market arena on the proverbial shield.

Using the deep value approach to the markets allows you to profit from the mistakes and blow ups of others. The process forces up to adapt to changes in the market and economy and allows to achieve the most important goal of surviving long enough to thrive.

About the author:

Tim Melvin
Tim Melvin is a value investor, money manager and writer. He has spent the last 27 years as in the financial services and investment industry as a broker, adviser and portfolio manager. He has also written and lectured extensively on the markets with his work appearing on RealMoney.com, DailySpecualtion.com, Benzinga.com as well as several print publication including Active Trader and the Wall Street Digest.

Visit Tim Melvin's Website


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