Two things that work

Dear Gala,

For as long as there have been markets, people have looked for the trick: the rule, the pattern, the thing that beats everyone else. Almost everything ever proposed has failed, usually right after being discovered, and often expensively. I want to tell you about the two that did not. They have been tested in market after market, country after country, across more than a century of data, and they are still standing. And then I want to tell you why almost nobody manages to profit from them, because that is the real subject of this letter.

Value

The first is value. Buy what is cheap compared with what it earns and what it owns. The idea is as old as investing itself; Benjamin Graham was teaching it in the 1930s. For decades the academics treated it as folklore, until they measured it. In 1977 Sanjoy Basu showed that companies with low prices relative to their earnings had been quietly beating the market for years. In 1992 Eugene Fama and Kenneth French, the guardians of the efficient market itself, confirmed it across half a century of American stocks: cheap had beaten expensive, by a lot, and the standard theory could not explain why. My best guess is that it works for two reasons at once. Cheap companies are usually cheap for a reason, so part of the extra return is payment for carrying real risk. And people give up on them too completely. A company that has disappointed for three years feels like a company that will disappoint forever. That gap, between how bad it feels and how bad it really is, is where the extra return comes from.

Momentum

The second is momentum. As simple as it may seem, what has gone up over the past year tends to keep going up for a while longer. That is it. That is the whole finding. In 1993 Narasimhan Jegadeesh and Sheridan Titman documented it in American stocks, measured over horizons of three to twelve months, and half the profession refused to believe it, because it should not exist: if prices already reflect what is known, yesterday’s return should tell you nothing about tomorrow’s. Yet there it was, decade after decade. The best explanation is again human. People react to news too slowly, and then, late, they chase it. News moves through a market the way a rumor moves through a school: for days nobody has heard it, and then suddenly everyone has always known it.

Opposites

Now the part I find beautiful. These two ideas are opposites. Value buys what everyone hates; momentum buys what everyone loves. One bets that the crowd has overdone its despair, the other that it has not finished its enthusiasm. And because they are opposites, they tend to fail at different times. In 2013, Cliff Asness, Tobias Moskowitz and Lasse Pedersen published a paper whose title says everything, “Value and Momentum Everywhere,” and found both of them working in stocks in every major region, in government bonds, in currencies, in commodities. They also found that the combination was steadier than either alone, because when one was suffering the other was usually fine. Two flawed things, opposed to each other, holding each other up.

The hard part

So if this is so obvious, why isn’t everybody rich? Because both of these, on top of working, hurt. Value spent most of the 2010s losing to expensive, glamorous stocks, year after year, for so long that serious people wrote essays about the death of value, roughly in time for it to come back. Momentum fails differently: suddenly. When a crash ends and the market turns, the stocks that had been falling hardest bounce the most, and a momentum portfolio, positioned exactly wrong, can be destroyed in weeks. It happened in 1932, it happened when the internet bubble unwound in 2001, and it happened again in 2009. A strategy can work over many years and still put you through stretches so bad they feel unbearable. Most people quit in one of those stretches, usually right before it turns. That is not a flaw in these two ideas. It is the reason they still work. The return is the payment for that pain. It is also why Asness and his co-authors found that the simplest recipe, half value and half momentum, works best of all: when one is at its worst the other usually is not, so the pain becomes survivable. Survivable, not painless.

Your mother and I are like that too. When one of us is not at our best, the other pushes through for the two of us. If we do it right, you will never notice. But beware: the mix only pays if you have the stomach to hold it through its own bad years (most marriages too, by the way).

What I do

What do I do with all this? Less than you might expect. The conclusion is not to go hunting for clever strategies. It is this: if you ever use these two, use them together, in a size you can hold through a bad decade, with the rules written down in advance, or do not use them at all. The worst option, and by far the most common, is to adopt one after reading about its great years and abandon it after living through its bad ones. That converts a working idea into a machine for buying high and selling low, and the machine runs on your own money.

With love,
Papá