Davis found that style-timing rules did not generate high average returns despite having future information about BtM spreads. In fact, he concluded that the expected excess return of style timing is probably negative—for the same reasons that efforts to try to time the overall market are likely to fail. Just as there should always be an expected equity risk premium, ex-ante there should always be a value risk premium. And as is the case with the equity risk premium, the value premium is so large that any trading strategy would have to be right almost all of the time to deliver successful results. It would be like switching from the high-speed carpool lane to the center lane on a crowded freeway. Your "freeway algorithm" might help predict when the carpool lane or center lane will move faster or slower than normal. But will it be accurate enough to justify switching into the slower lane in an effort to get there quicker? The evidence suggests that you are better off staying in the carpool lane. The lesson for investors is that the existence of a statistical relation does not necessarily imply that a profitable trading strategy based on that relationship exists, especially after accounting for trading and other costs.

Summary

Investors in high-returning asset classes should not be surprised when the risks show up. Instead, they should be pleased that it does show up occasionally because otherwise they would not have the opportunity to earn the expected risk premium. Of course, experiencing periods of underperformance and bear markets are painful, but there is an old adage that seems appropriate—"no pain, no gain."

One of the important keys to financial success is having knowledge of financial history. Those that do not know that there will inevitably be periods of underperformance may fall prey to tracking error risk and abandon their plan. But investors that have the knowledge history provides are forewarned. Thus, they will be more likely to have the discipline to stay the course. In fact, disciplined investors look at periods of underperformance as opportunities to buy stocks when they are on sale. In other words, the market is a mechanism that transfers wealth from those with a strategy and strong hands to those without one and weak hands.

The bottom line for investors is that the prudent strategy is to ignore the calls to alter your investment plan that you hear, be they from your stomach, Wall Street or the financial media. The only actions you should be taking are rebalancing your portfolio and harvesting losses for tax purposes. Those that have the discipline to stay the course will avoid the fate of the typical investor who underperforms the very mutual funds they invest in by a significant margin (because they keep altering strategy and chasing past returns).³

¹Charles Ellis, Investment Policy (Irwin Professional Pub 2nd edition 1992)

²James L. Davis, "Does Predicting the Value Premium Earn Abnormal Returns?" January 2007

³Morningstar FundInvestor (July 2005)

Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn't Want You to Know (2000), Rational Investing In Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003); and co-author of The Only Guide to a Winning Bond Strategy You'll Ever Need (2006). He is also a principal and director of both Research of Buckingham Asset Management and BAM Advisor Services—a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices—in Clayton, Missouri (www.bamservices.com).

His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.

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