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Testing Investment Strategies

At least a couple times every week, I’ll get an email or comment on the blog explaining why I’m an idiot for recommending a buy & hold index fund strategy. Usually, the writer is kind enough to share a strategy that they’ve been using successfully to earn “very impressive” returns.

The following are the 3 questions I ask about an investment strategy to determine whether or not it’s worth looking into further.

How has it performed in the past?

If I read about a strategy and I see that it’s underperformed the market for the last 20 years, I’m unlikely to be interested. Similarly, seeing that a strategy has worked well over the last 12 months isn’t terribly meaningful. At a bare minimum, I’d want to see how it has performed during both up and down markets.

Why has it worked?

While respectable past performance is necessary, it certainly isn’t sufficient. From 1983-1993, butter production in Bangladesh famously proved to be a nearly perfect predictor for performance of the S&P 500. Yet (thankfully) I don’t know anyone who actually invested their money based on butter production levels.

If–even with the benefit of hindsight–there doesn’t appear to be a reasonable explanation for why a strategy has worked, I’d steer clear.

Why should it continue to work?

Without a doubt, this test is the hardest one to pass. In my opinion, for an investment strategy to be worthwhile, there must be reason to think that either:

  • The strategy will never become widely known, or
  • The strategy will continue to perform well even if it does become widely known.

For most market-beating strategies, the reality is that they’ll stop working soon after they’re discovered by the major market players. That’s simply the nature of a market with literally millions of competing investors.

Buy & Hold with Index Funds

To date, a buy & hold indexing strategy is the only one I’ve found that provides answers that satisfy me.

As to their performance: Index funds have consistently outperformed the majority of their actively managed competition.

As to why they perform well, it’s plain common sense:

And the best part: The strategy will continue to work just as well even as it grows in popularity. You buying and holding index funds does not hinder my performance in any way, despite the fact that I’m using precisely the same strategy.

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  1. Great points, Mike. What you’ve really nailed is the question of whether the strategy will continue to work. You’re right that almost every “strategy” will fail if everyone starts using it. I believe even Mr. Bennett’s strategy would fail that test.

  2. Rob Bennett says

    I don’t agree with your conclusion that buy-and-hold is the way to go, Mike, but I think your three tests are perfect.

    A strategy must make sense; if not, data means nothing. That said, having the data support you is a big plus. The benefit here is that data is objective while your own thought processes are subjective. You need to get outside yourself and looking at the historical record permits you to do that. And, yes, you need to think through whether the strategy is going to continue to work or is just some gimmicky thing that happens to backtest well for a time. That third test is a check on the validity of the first two.


  3. There is one more question I like to ask when considering an investment strategy:

    What happens if it doesn’t work?

    The consequences of of an investment strategy that doesn’t work is a financial setback. Then you have to make up for it, usually by saving more and/or saving for a longer period of time. Alternatively, it might mean cutting back goals or having to alter your plans.

    When figuring out how much we have to save, for how long, and how much we’ll have to spend in the future, we already have to deal with the uncertainty of what the markets will do. Trying to beat the markets just adds another layer of uncertainty; whatever the market does, you now don’t know whether or when you’ll do better or worse or by how much.

    In the grand scheme of things, sharing in the market’s performance less the cost of low cost index funds, should leave us well served (at the very least, serve us better than trying and failing to do best them). And, as far as making plans and setting savings goals, does it really make sense to plan to beat the markets and be the exception to the rule? (This may be the 5th question to ask.)

  4. Dylan makes a good point — for most people who aren’t paid to beat the market, beating the market is *not* the aim.

    In fact, not even matching the market is the aim. Long-term comfort (in retirement) and short-term comfort (being able to cope with whatever volatility their capital exhibits) is the aim.

    It’s what makes things like the Permanent Portfolio such a good idea. Almost certainly lousy versus excess stocks over even the medium term, but probably great for most people’s needs, if set up cheaply.

  5. Building off what Dylan and Monevator said, people get caught up in returns and loose track of their real goals. Is your goal to get a certain return? Or to have your assets perform at a certain comparability to the market? Mine aren’t. I don’t want my future or the future of my loved ones to depend on whether I get a 9% return vs a 7% return. That should not be detrimental to me. I want everything to be okay whether things work or not. Is that too much to ask?

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