Q2 2017 CIO Insights – Disciplined Equity
In the prior edition of CIO Insights, we wrote about why we thought it was so difficult to invest on the basis of politicians’ language and proposals. Now, in the early stages of the Trump administration, things are no more clear on a whole range of policy fronts. In this edition, we argue that investors would do well to recognize that uncertainty (political, economic, market) is the normal state of affairs, rather than the exception to the rule. As a result, financial success depends on developing a process for making decisions under conditions of uncertainty.
We See What We Are Looking For
Superforecasting: The Art and Science of Prediction is a brilliant book by Philip Tetlock and Dan Gardner about the limits and difficulty of prediction. There are many useful lessons about investing that we can draw from this book, and we strongly encourage you to read it. Two of their findings in particular are worth highlighting here:
- Decision-making works best as the product of a self-critical, multi-step process; and
- People naturally tend to see what they are looking for, so better to employ a multi-faceted view of problems—or what the authors call looking through “dragonfly eyes.”
With this in mind, let’s return to politics. When investors look at President Trump’s policy proposals, what do they see? With stocks at record highs, it is safe to say that many take at face value the promise of tax cuts, favorable trade deals, infrastructure spending, better growth, and less business regulation.
On the contrary, we believe that while politics may make for good TV, they’re not very compelling as an investment thesis. Indeed, it’s not clear which of these policies will be implemented, and in what form. It’s no coincidence then that there are no political inputs in our stock selection model.
For our part, we have long argued for the benefits of a multi-factor stock-ranking model, our own analysis indicating that a broad, diversified approach to stock selection enhances the consistency and predictability of performance. In Tetlock’s terms, our dragonfly eyes are defined by the four broad factor families—value, momentum, growth and quality—and underlying inputs we use to synthesize a critical, analytical view of every stock in our universe.
Objective, Systemic, and Disciplined
In line with Tetlock’s argument calling for a methodical approach to forecasting, we believe that the consistent application of an objective, systematic, disciplined process can be particularly beneficial under uncertainty. We define an objectively driven investment process as one whose evaluation criteria and portfolio construction practices are inherently sensible and thoroughly tested and validated. Second, we believe that a systematically applied investment process should make it easier to evaluate and address potential sources of underperformance.
In addition, having rigorous, consistent standards for evaluating current and proposed new steps in this process aids in the evolution of the stock selection model. “Discipline” emphasizes that we adhere to our investment process regardless of the short-term volatility and uncertainty in financial markets. We believe that individual investors could also benefit from a similarly disciplined, objective approach to their own portfolios amid uncertainty.
Finally, it’s worth noting that Tetlock and Gardner say that “all models are wrong.” We hold this idea in our minds at all times and are constantly evaluating the efficacy and limits of our own stock selection models. Indeed, elsewhere in the book, they say that “beliefs are hypotheses to be tested, not treasures to be guarded.” This is a brilliant summary of what we are trying to achieve by constantly gathering data and evaluating the efficacy of our stock selection process.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of Scott Wittman, CFA, CAIA, and are no guarantee of the future performance of any American Century Investments portfolio.
For educational use only. This information is not intended to serve as investment advice. Past performance is no guarantee of future results.