Doubt is not a pleasant condition, but certainty is an absurd one. – Voltaire
I’m a fan of books written by Michael Lewis. A few that stand out are: Liar’s Poker, Moneyball, The Big Short, and Flash Boys. Lewis’ latest work, The Undoing Project, focuses on the lives and work of two Israeli psychologists, Daniel Kahneman and Amos Tversky. Kahneman and Tversky are primarily responsible for trends leading to mistrust human intuition and defer to algorithms. While I am only a little over one-third through the book, I am struck by the phrase – “defer to algorithms” and how they pertain to investing.
If you step back and think about it, the three primary investment models used here at ITA Wealth Management, all rely on algorithms. Take the Strategic Asset Allocation Model. This method of investing is built around the principles of asset selection and the percentage to invest in each asset class. After these two basic ideas are determined, the easy choice is to select which ETF will be used to populate each asset class. Intuition and/or emotions are removed from the investment model. Once the critical decisions are made, the stock market does the rest. All the SAA investor needs to do is to keep the asset classes in balance. As I wrote earlier this morning, I tried to out-guess the market and held cash back when the Copernicus and Pasteur were first launched. That intuitive/emotional decision cost money. I would have been better off to fully populate each asset class and set the portfolio on its way. No, I thought I knew better.
Similarly, the Dual Momentum Model (DMM) is entirely built around an algorithm. Few decisions are initially required. We need to decide on the look-back period, what cutoff ETF to use, and what ETFs to include in the investment quiver. The ITA DMM uses a 252 trading day look-back, SHY for the cutoff ETF, and VTI, VEU, and BIV as the principle securities for investing. A set algorithm drives the Dual Momentum Model. Emotions are removed from the process. Stick with the plan is the guiding principle.
The third management model is the Tranche Momentum Model (TMM) or an extension of the DMM. Without going into great detail, the TMM is the guiding investment plan used by these portfolios: Curie, Newton, Einstein, Kepler, Bohr, Gauss, and Huygens. While there are a few judgment calls with this model, algorithms drive those judgments. Emotional decisions are minimized in this investment model.
I’m looking forward to completing the final two-thirds of the Lewis book as I anticipate he will delve into the importance of using algorithms when it comes to making important decisions.