Investing, Jogging and Their Unlikely Connection with Potato Chips

Julian Koski, Co-Founder and Chief Investment Officer, New Age Alpha
May 29, 2020 12:08:33 PM 4 min read

Nowadays, it seems more and more people are engaging in the time-tested exercise of running. Gyms are closed, yoga classes are too dangerous. What better time to get outside for some fresh air and stress relief? Well, a friend once advised one should run as if holding potato chips. Which is to say: open-palmed but with fingers still cupped. You see, imagining the delicate chips cradled inside prevents you from clenching your fists. And though not obvious immediately, this common mistake can have serious deleterious effects on your jogging. The act tightens your muscles up through your arms and lands squarely on your trapezius muscles behind your neck. Anyone who’s recently started running has felt this soreness the next day. This tension stresses your muscles, tires you out and is entirely unneeded. By keeping your hands relaxed you can avoid this worthless drag on performance.

But did you know you can, metaphorically speaking, employ this trick in your investment portfolio as well? The H-Factor is the risk that comes from humans interpreting vague or ambiguous information in a systematically incorrect way. Investors aren’t aware of it and aren’t compensated for taking it, yet this risk erodes alpha. Similar to the drag created by running with clenched fists, investors don’t realize the damage done to their performance by such a basic yet insidious threat. In turn, our H-Factor System provides the means by which you can monitor and mitigate this risk.

What you don't know will hurt you

One of the most basic axioms in many facets of life is the notion, “What you don’t know WILL hurt you.” Think of it in nature: the camouflaged predator waiting to strike…or the brightly colored and completely unguarded prey that’s wildly poisonous. Evolution has made both a science and an artform of deception. With this, and the previously described jogging inefficiencies in mind, please glance at these charts:

 

 

Charts

 

 

Comparing them quickly, Fund A on the left is crushing it! Each fund has predictable performance with no drawdowns/low volatility. But, relative to the modest improvement in Fund B on the right, Fund A is easily the preferred investment, right? Well no. And the difference is obvious: Fund A’s performance is presented in whole dollars while Fund B’s is presented as a percentage. So the question concerning Fund B should be, “The percentage of what?” While we know Fund A went from $1,000 to $3,650, we don’t have a clue about Fund B’s assets. If you had a billion dollars invested in Fund B, the $2,650 gain in Fund A would seem like peanuts.

The example above is a crude but effective way to illustrate a gap in knowledge. Meanwhile, as a form of exercise, jogging may also be the crudest and most effective—it doesn’t require the skills of a tennis player or the equipment of a bodybuilder. Yet some still suffer from the clenched fist knowledge gap described earlier. Similarly, you might not be aware of it, but gaps in knowledge also may be hurting your investment performance in the form of the H-Factor. And also, similarly, there’s a way to avoid the H-Factor.

How about admitting you can't know everything?

Owing to this implicit knowledge about financial risk, many people set about trying to know more. They study finance, they study behavior, they study quantitative theorems in hopes of predicting the market. They think that if they only study enough they’ll know a bargain when they see it. And that’s exactly the problem.

At New Age Alpha, we turn the whole notion of knowledge and prediction on its head. We don’t follow the herd and try to guess what stocks will be the winners. Instead, we admit that we cannot predict the future, that there will always be gaps in knowledge—no matter how much we study. We’d rather admit this deficiency in our predictive ability of winners and simply focus on avoiding losers instead. Using a probability-based system, we strip human biases out of our investment decision-making like an actuary at an insurance company. After all, why take risks if you’re not compensated for taking them?

Metaphorically, it comes down to this: you can stretch as long as you like, you can buy the best sneakers, and you can map out the most challenging route. But the next morning, you don’t want your investment portfolio to feel as sore as your neck because you carried unneeded risk on your journey.

 

Julian
avatar
Co-Written by Julian Koski, Co-Founder and Chief Investment Officer and Matthew Waterman, Investment Writer