Investment Strategy: Don’t Over-Rely on Stocks!

There are plenty of misconceptions about investment systems. It’s an esoteric field, so those on the outside tend to think of systems as mysterious, robot-driven, “black box” investment advisors.

Really, though, it’s not that complicated (or mysterious).

A systematic investment strategy starts with an idea… which turns into a hypothesis… which is then proven or disproven.

The idea can be as simple as: “I think cheap stocks beat expensive stocks in the long run.” (That’s the basis of value investing, and countless studies have proven it worthwhile.)

Of course, a keen observation about the markets can also be applied on a one-off basis. Take Kyle Bass – founder of Hayman Capital in Dallas – who, in 2006, created a hedge fund to exploit a single hypothesis: that the U.S. subprime mortgage market would implode.

That market did implode. And Kyle Bass was spot on and made a ton of money. But he’ll need to come up with a new great idea for his next fund, or “trade of a lifetime.”

That’s where a systematic investment strategy differs. Unlike Mr. Bass’ exploitation of a rare event, systematic strategies aim to exploit events that occur again and again, with a good deal of regularity.

Cliff Asness of AQR Capital Management (a quantitative/systematic hedge fund) explained the concept quite well when he was interviewed by Steve Forbes. He said (paraphrased):

With systems, you’re leveraging an idea… that cheap always beats expensive, or that low-volatility always beats high-volatility. And you’re applying that idea across hundreds of symbols… so that, in the long run, you’re exploiting the mathematical edge that’s contained in your idea.

To me, that’s the essence of a system. And that’s what I aim to do with