How To Detect False Investment Strategies
And why correlations might not be your best friend
A warm hello to all new readers! I’m glad you are on board.
New here? I’m Michael and on a mission to make beating the stock market as easy for you as choosing your favorite ice cream. I write an algorithm that does exactly that.
Read the short story here. And the journey so far here.
In a world full of investment advice, separating facts from illusion is a challenge. It feels a lot like sifting through a mixed bag of tricks and truths.
The saying ‘Not everything that glitters is gold’ couldn’t be more spot-on.
Let’s find out how you can cut through the noise.
Imagine you’re sprinting to catch a train. The faster you run, the more likely you are to make it on time, right? It’s a straightforward cause-and-effect situation, much like opening a window to let in fresh air or clapping your hands and hearing a sound.
Life, we assume, operates on these straight, causal relationships.
But what about when a bird shits on your shoulder, and you win the lottery the next day? Or when a sleepless night leads to a breakup with your girlfriend? Is there a pattern, a cause-and-effect? It’s tempting to see patterns in all kinds of events, but are they real connections or mere coincidences? I would say, that the last two examples are false positives and false negatives.
In the world of investing, everyone is on the search for those elusive, genuine cause-and-effect relationships that promise profitable returns. Yet, an entire industry thrives on selling us the dream of predictable outcomes based on so-called “proven” rules.
Take, for example, the widely accepted belief that:
Interest rate hikes break the stock market.
Recent history, however, has flipped the script, challenging many such investment “truths” and revealing that they have been false positives.
hit the nail on its head.I was fast and commented boldly along the lines of, “Only fundamentals count”.
But is that right?
How can we find that out?
Sheer accident has discovered many great things in life. Like the French croissant myth as many say, for instance. I stumbled upon a solution to the tough question above by pure luck and thanks to my curiosity.
Some context first.
I'm currently looking for ways to make data more digestible, and as I was searching Amazon for books on the subject, I stumbled across another book with an interesting title. So I did what I often do, I followed the shiny object and did some research on the author.
Let’s call him Professor X for now. Here is what he says about Correlations.
The Pitfall of Simplistic Correlations
Many turn to correlations as a safety net, clinging to the belief that a value close to 1 signifies a strong, reliable relationship between two variables. This approach, however, is a simplistic illusion that often leads to misconceptions. It’s easy to be swayed by these apparent patterns, but they frequently unravel, leaving us to grasp at straws while also getting us out of breath as we justify exceptions to the rule - just to see them crumbling over time as shown above when markets rise and fall.
Even if there is a correlation, what does that even mean?
Where Are the Limits of Correlations?
Outliers influence correlations a lot.
Correlations work best in linear relationships (If-then). Unfortunately, most relationships in investing are not linear.
If the distribution of your data is not “Normal”, their use is limited
Most don’t even know which algorithm they should use to create the best correlation.
The Core of My Investment Philosophy
This brings us to my investment strategy: distinguishing true value from fleeting opportunities.
Consider a new Ferrari on sale for just $1 – an undeniable bargain that one can easily sell with a profit. Yet, the search for such clear-cut deals in the investment world is full of complexities. Gone are the days when formulas like the Graham number could guide us to undervalued assets.
My approach centers on the fundamental relationship between price and value – like the Ferrari for $1. Note, that value is a very broad term. However, the real challenge lies in verifying the efficacy of this strategy.
The Tough Question
How can I ensure I’m not merely throwing a bunch of spaghetti at the wall, hoping something sticks? The key is to sidestep common pitfalls like selection bias and confirmation bias, which can cloud our judgment and lead us off the path.
What do I mean? If you have a bunch of data, you will find winning strategies - just by pure accident, but that doesn’t mean that they will work in the real world. We have to weed out the false positives and the false negatives, because, as in real life, only real relationships count.
Beyond the Obvious: Seeking Substance
Initially, I felt tempted to rely on conventional metrics such as beta, Sharpe ratio, average returns, and my favorite girl, the compound annual growth rate (CAGR). Yet, the ghost of false positives haunted me. He finally caught me and forced me to look deeper.
Enter the concept of the diluted Sharpe ratio, a refinement introduced by Professor X from Colon University and an authority on evaluating the true performance of investment strategies. Professor Marcos López de Prado‘s insights have been instrumental in many investment strategies.
The Ultimate Test
The focus is on dissecting the distribution of results to identify the diluted Sharpe ratio, aimed at unveiling strategies that statistically stand the test of time.
The goal?
To have an investment strategy that is grounded, not swayed by illusions.
So, here’s the deal: the big test for my investment strategy comes down to seeing how it stacks up against the S&P 500, especially when we talk about the diluted Sharpe ratio. If it turns out my strategy’s ratio is lagging behind the S&P 500, well, that’s my cue to call it quits on this path.
It wouldn’t mean I’ve failed, though; it’s more like hitting a reset button, ready to dive back in with fresh ideas and a new game plan. After all, it’s about finding what works in the long haul and you are live with me.
One last comment.
To all the guys out there who have an investment strategy that doesn't always work, and you have your supposed explanations as to why that was allegedly the case. I dare you to check your strategy with these tools because our ego is a powerful persuaded.
Dare to ask the tough questions and do the reality check.
Progress
I also dug deeper into the data visualization topic. I’ve created this picture and the following animation. Maybe next week I will explain a bit more about it.
Plan
Finish my diluted Sharpe ratio code.
Create more data visualization’s
What’s on my head
Your life, your rules. No comment is needed :-)
Nuggets I’ve enjoyed
Have a great day StockStar!
Hit that heart if you like true positives!
Michael
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I share my stock investment story without sugarcoating – you get the good, the bad, and those tricky ego trips. I'm developing a service with a mix of smart code and proven investment strategies, making stock analysis a thing of the past if you wish. Because life offers so much more beyond the confines of stock analysis.
Disclaimer:
The information in this article is my personal opinion. I’m not a certified investment professional. It is not consulting, nor does it constitute investment recommendations.
I do my research carefully and follow my personal investment strategy.
The stock market is a complex building with its own rules. There are no rules set in stone, like the rules of physics.
Therefore, use the contents of this newsletter at your own risk and do your own research as well. Investing in the stock market can lead to a total loss of the capital invested.
Will hang around and watch. Nice write up.