Adaptive Value Investing for the Long-Term Investor

is the Charles E. and Susan T. Harris Professor, a Professor of Finance, and the Director of the Laboratory for Financial Engineering at the MIT Sloan School of Management and one of the most prolific and influential researchers of market and economic behavior. Over the years, Lo has talked complex subjects such as options, financial engineering and risk management with groundbreaking results. He has also written two books on technical analysis that no one has ever read but everyone probably, especially practitioners of the charting and statistical methodologies should that draw some conclusions that will surprise you. Lo is one of the most prolific and influential market and economics researchers of the past several decades. Dr. Lo has developed a theory to challenge the efficient market theory that is still taught in many business schools but has been proven fatally wrong in practice for some time now. Rather than draw on just the pure rational thought and math of traditional economic research, Lo brings in theories of evolution, biology and neuroscience to develop what he calls the adaptive market hypothesis. The theory reaches five basic conclusions that have important implications for investors and is an interesting and worthwhile exercise to look at these through the lenses of a value investor.

The first conclusion, or principle, of the adaptive market hypothesis is the relationship between risk and reward is not stable and will change over time based in the condition of the market. This is something that has already been discovered by value investors. As market and economic conditions change the level of investment will naturally fluctuate based solely on the number of opportunities available that are safe and cheap. Chasing beta in the form of momentum stocks can be fairly low risk high reward activity when markets are rising consistently but is dangerous and financially fatal in markets that are drifting sideways or trending down. No manner how many fancy equations you use to try and determine the risk and reward relationship the fact that humans with natural biases, desires and fears are market participants the relationship will change constantly over time. As value investors it is out job to find ways to exploit that changing relationship by focusing on the risk first with the reward as a secondary factor.

The second conclusion is that arbitrage opportunities or anomalies are always going to be present. If they were not then there would be no point in research or price discovery and markets would pretty much cease to function. While value investing is not exactly arbitrage it is along with the small cap effect and momentum one of the longest running anomalies of all time for the simple reason that the large funds cannot play in our sandbox. Other arbitrage opportunities and anomalies are usually pushed out by the ecological cycle of the market when too much money comes into too small a space and the edge disappears. That is almost impossible in deep value stocks. With the exception of the aftermath of a meltdown or crash it is simply impossible to but tens of hundreds of billions of dollars to work in small cap deep value.

The third principle is that various strategies whether fundamental, technical, statistical or fundamental will work some of the time but not all of the time. Anyone who was a value investor in the 1990s knows that while basically true, there is a small hole in this part of the theory. Although we lagged the indexes, tech stocks and day traders are performance in absolute terms was actually quite satisfactory. The underperformance as it was was more due to the excess returns earned by the cycle of greed and euphoria that held the markets in its grasp than a failure of the principles of deep value investing. None the less we will underperform at various points in the market cycle.

Here, we switch the order of the conclusions around and address the one most list last fourth. The best way for an investor to earn decent long term returns is to be innovative. Market cycles and the factors influencing the market will always be changing so you have to adjust the way you look at the market and what you buy in order to earn solid long term returns. Here deep value investing excels as it is to a very large degree self-adapting. There is a forced timing mechanism that reduces and increase market exposure as the opportunities are created and eliminated. The pockets of value are always shifting in the market due to others fears and expectations. In the aftermath of the S&L crisis in the 1990s it was banks. During the Clinton-era attempts to reform healthcare, it drifted toward drug and medical stocks. In 2003 it was technology stocks. In 2008, it was banks once again and real estate related concerns. Today, the deepest pockets of value appear to be in material, energy and consumer electronics. Deep value automatically adapts based on the actions of other market participants and keeps you evolving with the market cycle.

The last and most important principles that primary job of a long term investor is to survive to reach the long term. By focusing on margin of safety first and returns second, the deep value business-like approach to the markets protects you from the risk of severe permanent loss of capital due to excessive risk taking or a simple failure to evolve as an investor. While nothing can eliminate quotational loss due to market fluctuations, an emphasis on business value rather than price movements can reduce the risk of an investment portfolio blowing up or leading to you being carried out of the market arena on the proverbial shield. Using the deep value approach to the markets allows you to profit from the mistakes and blow ups of others. The process forces up to adapt to changes in the market and economy and allows to achieve the most important goal of surviving long enough to thrive.