Should Investors Follow Fact or Superstition?

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Editor’s Notes: We are past the month of the Hungry Ghost Festival. It is perhaps now safer to publish this. *Crosses Fingers*

The financial world blurs the line between fact and superstition.

What do I mean?

Comparing 12 previous years of results, financial education website ein55.com found empirically that August remains the worst month in terms of local stock performance.

If you refer to his Oct 2018 article, the August months saw investors rack up investment losses 12 out of 12 times.

Having the worst months in August also plague Hong Kong markets, the other market that has a large ethnic Chinese population.

Local investors are well aware that August also corresponds to the Hungry Ghost Festival, where it is believed that malignant spirits will be allowed a month to take a vacation in the Earthly realm to attend Getai Festivals.

As such, evil spirits infecting the local stock-markets in August every year is not so much superstition, it is empirical fact.

Here are some investment ideas that straddle the line between fact and superstition in Singapore markets.

Superstition #1 – Stocks that grow the fastest generates the most profits for investors

When testing the STI performance in August 2019, we found that an equally-weighted portfolio of blue chips returns 7.58% over the past 10 years. To shortlist a set of blue-chip stocks, we chose 15 stocks with the largest one-year earnings per share (EPS) growth. If we had employed this simple growth strategy for the past 10 years, we would have underperformed the STI equal-weighted index and made only 5.43%.

The idea that growth stocks outperform is clearly a superstition and do not apply, at least, to the largest blue chips in Singapore.

Superstition #2 – Buy cheap REITs stocks because they outperform the expensive ones

The core tenet of value investing is to buy stocks on the cheap. The idea is that you purchase stocks with the lowest price to book value so that as time goes by the stocks will revert to a market price closer to the intrinsic value.

This assertion is false in our REITs market. Taking REITs as a whole, the asset class has done well for the past 10 years, returning 15.21% over the past 10 years.

To isolate the cheapest REITs, we approximate the Price to Net Asset Value by choosing half of the REIT universe with the lowest Price to Book ratio. If we employ this strategy, the portfolio underperforms, returning only 14.41% over the past 10 years.

Clearly, the idea of buying the cheapest counters do not apply to the REITs sub-sector. The ideas that the cheapest counters outperform is also a superstition.

Superstition #3 – Capital Assets Pricing Model

The Capital Assets Pricing Model (CAPM) posits that the expected return of an asset is equal to risk-free rate plus a market premium multiplied by the beta of the asset. Pioneers of this theory have even won an economics Nobel prize for their academic work.

The baseline performance of a portfolio invested in Singapore small-cap stocks sans REITs and China stocks returned a mere 4.49% when back-tested over the past 10 years.

When we isolate half of the set of Singapore stocks with the lowest Beta or volatility relative to the rest of the markets, returns were boosted slightly to 6.54%.

This means that contrary to what was posited by the CAPM, you can expect returns to be higher for Singapore stocks when lower beta counters are chosen in a portfolio.

The Capital Assets Pricing Model that won at least four economists a Nobel Prize can be reduced to a mere superstition at least in local stock context.

Why Do We Look At Things Empirically?

They like to say in the armed forces that they will kill you in training so you don’t get killed on the battlefield.

That is a level of realism and grit that I feel is lacking as a whole in the field of finance.

I say this with the full conviction of someone who has been trained as one. I have passed all three levels of the Chartered Financial Analyst Program. I even hold a Masters in Applied Finance from NUS.

To date, I would probably have been better off spending time and resources trying to read research papers by quantitative practitioners on what has worked in the markets.

Had I tried to apply the methods learned by most financial professionals, I would probably not have been able to retire on 6-figure dividends annually. I’d be too busy wondering why my ivory tower/Nobel prize-winning methodologies don’t really work in the markets.

That is why I have an emphasis on staying empirically driven. When you’re empirically driven, your methods have been proven to work. When you’re empirically driven, your methods are driven by evidence, not fantastic theories with little place in practicality.

That is the way we should be investing.

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