PWL Capital January 29, 2014 Advanced Investing Market Research The Colour of Money Investors are always seeking patterns and trends to exploit, but do they exist? Colour maps are a visual representation of how different asset returns (E.g. U.S. equities, Canadian bonds) change over time. In the example below there are eight asset classes, each represented by a different colour. They are ranked, with the highest performing asset for a particular quarter in the top row and the worst performer in the bottom row. Thus, for example the dark green block in the top row in the Q1 2011 column of Map A indicates that the asset represented by this colour outperformed all other assets in the first quarter of 2011. Both maps show the same asset classes over the same period. One of these maps uses historic data, the other uses data generated at random. Which is the true map? Many investment firms will base their investing decisions on predicting the future. Predictive investing typically discerns patterns in past performance and relates these changes to changing economic circumstances. Economic forecasts are then used to predict future market performance. Humans are blessed with amazing pattern recognition skills to the extent that we share a tendency to find patterns where they do not exist. Is it clear which map is random and which is based on real data? In either case, is there anything of value in this data to predict the colour maps for asset class returns in 2014? A casual glance at either map raises obvious questions about any short term links between economics and market returns. Inflation, interest rates and unemployment can hardly be the reason for the rapid shuffling of the colours in either Map A or B. The overwhelming evidence is that actual short term asset class returns, from one quarter to the next, cannot be distinguished from a random process. Even with our great pattern recognition abilities, we are looking for something that does not exist. Even worse, if we believe that patterns are there to be found, we find them even when they are absent. The road to success (and peace of mind) is not to play the pattern recognition game, nor pay money to those who offer to play it on your behalf. An investor who refused to play and simply bought an equal amount of each asset starting in April 2010 would have made a gain of 30.23% by the end of 2013. All the assets in the colour map have positive long term expected returns and combining them reduces the potential for losses. This market based investing approach focuses on avoiding the costs and risks associated with predictive investing and passes those savings to investors, where they truly belong. Below we reproduce the real colour map, Map B, along with the percentage return data for each asset class. Source: Dimensional Fund Advisors PLC Share: Facebook Twitter LinkedIn Email
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