Base Rate Magic

Most of the success in investing is based on two things, that are essentially very simple (but difficult to accomplish in practice):

  1. Filtering out useful information from useless noise to build a good investment process – i.e. finding out what to do.
  2. Following that process consistently – i.e. not to do dumb things.

Contrary to the prevalent tendency to bash the very idea of active investing, I think it pays to have a good investment process (it may simply concentrate on being as un-active as possible). In my opinion, there is no such thing as passive investing – active decisions necessarily have to be made and a rules-based process helps to make good decisions.

Filtering information to build such a “good process“ is what this post is about.

Why is good decision making in investing so difficult?

One truth is, that the investing landscape is very competitive with highly skilled participants and there is only so much return to go around overall. Outperformers and underperforms equal out to produce that average return: the famous Zero Sum Game. It is important to note, however, that the sum in the investment game is not zero, but the average market return, that anyone can achieve. Unfortunately a range of studies has shown that the majority of individual investors consistently fall into the camp of the underperformers.

A big reason for these bad results is an overload of useless noise disguised as valuable information or relevant news, which often leads to bad decisions driven by the human emotions of fear and greed.

There is fairly strong evidence, however, that there are sound investment principles, that are very likely to contain a significant edge, that leads to outperformance over the long term. 

Some of these are (in no particular order or effort at completeness):

  • concentrating on broad asset allocation
  • focusing on the long term
  • diversification
  • breaking market cap weighting
  • return factors, especially value and momentum (trend)
  • earning carry (getting paid for holding a position even if price doesn’t change) and other alternative risk premia

Other areas are not likely to lead to an edge (but much effort is poured into them anyway):

  • picking individual stocks
  • short term trading
  • panic selling and greedy buying (following the crowd)

The Base Rate

What is a simple filter that we can employ to reach such a list of useful ideas to concentrate our research on? The best rule, I have ever come across is this:

Never do anything, that goes against basic, long-term probabilities.

In statistical terms this is called a favorable base rate: all investing ideas have to pass the test of having a basic probability to yield positive returns that is strongly in our favor in their simplest form: A positive edge.

As a negative filter the base rate can be used to easily screen out an enormous amount of useless information: simply discard everything without an obvious edge.

Look for strategies that tend to produce superior risk-adjusted returns in the long run, even when using only the most general rules and parameters or even none at all (e.g. being long equities). If you can figure out a solid reason for their sustainable outperformance, then these are investment approaches that really work.

How to do that in practice?

Collect information on the long-term historical risk-adjusted return of different investment approaches: asset classes, return factors, trading strategies etc.. Radically narrow your investment universe to strategies that show favorable basic probabilities across long periods of time. These are opportunities with a natural edge – you can select the ones with the best historical results and combine them into a portfolio using additional criteria.

To be able to do this, it is necessary to find solid resources that provide systematic rules and the resulting historical statistics or to generate the statistics yourself. Be careful: a lot of trading lore is based on heresay and is easily recognizable by the missing statistical data. As a rule of thumb: do not believe anything without data.
The reverse holds true for solid investment approaches: good data about them is available plentiful.

This is hard work (luckily someone smart wrote the book on it already), but there is no way around it if want „own” your decisions. Always ask yourself: what do I really know

Two examples for using the base rate

The Equity Risk Premium

A highly favorable base rate can be found in the fact that stocks produce superior returns over time – the equity risk premium. It is is the utterly convincing reason that stock market returns are the basis for the vast majority of investment portfolios and, at the same time, shows clearly that long term investing has much higher chances for success than short term trading. 

What is the probability to see higher stock prices after…?

Individual Stock Selection

An area that consumes the attention of professional and individual investors alike is analyzing which stocks to pick. A massive amount of information about individual stocks is spewed out daily and the best way to deal with it is (if you listen to the base rate filter) – just ignore it all. This wisdom has been percolating through much of the investment community for a long time and is the reason for the rise of passive index investing – study after study shows, that hardly any stock picking fund manager manages to outperform his benchmark index over time.

One particular study by Hendrik Bessembinder (Do Stocks Outperform Treasury Bills?) digs into the reason for that: over 65% of all stocks underperform their index and less than half of stocks deliver any gains at all. A blind stock pick is likely to lose money, which means basic probabilities are not on our side here.

Why go with basic probabilities?

There are enough ways to invest out there, that will give you positive long-term return expectations through historically persistent risk premia (returns over the risk-free rate) and strategies, that withstood the test of time and that have a compelling explanation. There simply is no need to fight an uphill battle against basic probabilities in search for an edge. Going against the base rate makes it much harder for a strategy to succeed. Your skill must be consistently above average – and that includes all professional managers out there. Chances are, that your portfolio will underperform or lose money.

Randomness and uncertainty are the major factor in investing and we always want to have basic probabilities on our side.

Annie Duke wrote a great book on the subject of decision making under uncertainty called „Thinking in Bets“. Here she lays out the idea of analyzing prior probabilities to judge the quality of a decision – and not use the actual decision outcome which is greatly influenced by good or bad luck.

For me this has proven to be an extremely powerful filter, it has completely transformed my approach to investing and my success. I do not aim to generate alpha (through unique sources of return), but instead concentrate on combining many diverse sources of beta (market returns), including alternative beta (through well known return factors and trading strategies).

A major conclusion, that I have come to is, that the biggest inefficiencies can be found at the highest level – making asset allocation decisions. On that meta level, I look at fundamental and technical indicators (each of which have passed the base rate test) to systematically rotate a portfolio between risky and safe assets according to market conditions. I want to be fully invested whenever we can expect exceptional market returns with a higher probability and be on the safe side when we are facing increased risks. To be on the right side of the market is what really matters. Find out more about the Meta Strategy here.

You can follow how I invest according to the Meta Strategy in my own portfolio by subscribing to my newsletter here – it includes a defensive and an aggressive ETF model portfolio with all the ticker symbols and other details for US as well as EU investors.

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