More success for momentum investing

This is not an isolated instance. In the last five years, our momentum portfolio has risen more than 150 per cent - putting it 35th of 241 All Companies funds - and since December 2004 it has trebled, while the FTSE 350 has gained just 50 per cent.

The likeliest explanation for this outperformance is that stock-pickers are Bayesian conservatives. They attach too much weight to their prior beliefs about companies, and not enough weight to news. This causes them to underreact to evidence that a company is improving, which means that share prices don't rise sufficiently in response to such evidence. This, in turn, means that share prices continue to drift up after getting some initial good news, giving nice profits to the investor who buys past winners.

Under-reaction doesn't just apply to good news. It also applies to bad. Our negative momentum portfolio - which comprises past poor performers - fell by almost 10 per cent in 2013. This is consistent with investors mistakenly hanging onto past losers in the hope they'll come good, which causes share prices to fail to fully embody bad news immediately with the result that they gradually drift down.

But the fact that good performance is due to a cognitive bias among stock-pickers does not guarantee that we can make future profits on momentum stocks. Our portfolio carries behavioural risk - the danger that investors have wised up to their error, and so have piled into momentum stocks, with the result that their prices are now too high.

The very fact that the new members of our momentum portfolio have done so well recently - by definition - is consistent with the possibility that investors have indeed learned from their past mistakes. And behavioural risk has materialised, albeit briefly, in the past; our momentum portfolio underperformed in early 2005, in 2009-10 and in much of 2012.

There's another portfolio that's vulnerable to behavioural risk - our low-risk portfolio, which comprises the 20 lowest-beta stocks. Over the last three and seven years, this has beaten the market, and in the last five it has done better than its lowish beta would predict. But thanks to a slightly disappointing fourth quarter, its 2013 performance was indistinguishable from what orthodox economic theory predicts that defensive stocks should do.

Of course, this could be mere noise. But it might also be a sign that behavioural risk has materialised - that investors wised up to the past under-pricing of defensives last year, and so bid up their prices, to a level from which returns have been mediocre.

Whether this means the defensive anomaly has disappeared depends upon why it existed in the first place. One possibility is simply that investors have under-rated the merits of dull, familiar shares with the result that they've been under-priced on average and so delivered decent returns. If this is the case, there's reason to fear that investors should have wised up by now - especially as the evidence for the defensive anomaly should by now be well-known.

The other possibility, though, is that there's an institutional reason why defensives have been under-priced on average. It's that - for many fund managers - they are, in fact, risky. They expose us to the danger of underperforming if the market rises a lot. People who care about relative performance would want to avoid this risk. To the extent that this is the case, defensives do well because some investors must be compensated for the benchmark risk which they carry. This implies that - on average - defensives should continue to do well, if only as a reward for taking a risk which others want to avoid.

Despite the defensive and momentum anomalies, we should not dismiss conventional economic theory entirely. In one respect, the capital asset pricing model - the idea that shares' returns are a function only of systematic risk - has worked well recently. I'm thinking of the performance of our high beta portfolio. In the last one and three years, this has done pretty much as well as you'd expect it to do in light of its beta. Granted, the portfolio has done very well in the last five years - but then it would have been a very brave investor who had piled into high-beta shares in late 2008, so perhaps such a return is a reward for bravery.

Although market risk - beta, or covariance with returns on the market - is an important systematic risk, it is not the only one. Another is cyclical risk - the tendency for some stocks to do badly in recessions. This risk helps explain the performance of our value portfolio - the highest yielders in the market. These have done well in the last five years. But this is largely because fears of recession have abated, which has caused a rerating of stocks vulnerable to recession. When recession fears increased in 2008, high yielders did appallingly; they included housebuilders and mortgage lenders at the time.

You might wonder what the point of all this is. Simple. It's to break the link between stock-picking and ego. Conventional investors - amateur and professional - think that stock-picking is a battle of wits, and so beating the market is a sign of ability and underperforming is a sign of incompetence. But this is not necessarily so. My portfolios show that if you pick the right strategy you can beat the market even if you know nothing about individual stocks. The investor who had, by luck or judgment, selected a momentum strategy a few years ago would have beaten most fund managers even if his execution of that strategy has consisted of nothing more intelligent than blindly buying a handful of good past performers. And the fact that a no-thought policy of buying past winners has outperformed most unit trusts - most of whose managers rely upon judgments about individual stocks - tells us that judgment adds little value to the right strategy, and often subtracts value.

This is not the only example of how strategy beats micro-judgment. Economists at AQR Capital Management have shown that Warren Buffett's success has lain not in his choice of particular stocks, but rather in his strategy of buying quality, defensive stocks; they show that other bundles of such shares did roughly as well as Mr Buffett's actual selections.

What matters for stock-pickers, then, is not (just?) opinions about particular stocks. It's about spotting strategies. Some strategies can pay off by exploiting investors' irrationality; this is true of momentum investing. Others, such as high-yield investing, pay off by taking cyclical risk. And others - such as perhaps defensive investing - profit from a mix of exploiting others' cognitive biases and taking a risk others are avoiding. If you get the right strategy, you can beat the market without much effort or intelligence.

The new benchmark portfolios

Megacaps (the 20 largest stocks): AstraZeneca, Barclays, BAT, BG, BHP Billiton, BP, Diageo, Glaxo, Glencore, HSBC, Lloyds Banking, Prudential, RBS, Reckitt Benckiser, Rio Tinto, Royal Dutch, SABMiller, Std Chartered, Unilever, Vodafone.

High Beta (the highest beta stocks in the last five years): African Minerals, Amerisur, Barclays, Enterprise Inns, Ferrexpo, GKN, Grainger, Gulf Keystone, Howden Joinery, Intermediate Capital, IPF, Kazakhmys, Lloyds Banking, Northgate, Petra Diamonds, RBS, Travis Perkins, Trinity Mirror, Unite, Vedanta.

Value (the highest dividend yielders): Admiral, African Barrick, Amlin, Astrazeneca, Berkeley, BHP Billiton, BP, Carillion, Fresnillo, HSBC, Imperial Tobacco, Man, National Grid, Phoenix Gp, Redefine Intl, Resolution, RSA, SSE, Std Chartered, Utd Utilities.

Low risk (the lowest betas in the last five years): African Barrick, Blinkx, Cineworld, Cranswick, De La Rue, Dechra, Dignity, Dominos Pizza, Drax, G4S, Hochschild, James Halstead, Londonmetric, Qinetiq, Randgold, Severn Trent, SSE, Synergy Health, Telecom Plus, Wm Morrison.

Momentum (the biggest risers in the last 12 months): ASOS, Bk of Georgia, Blinkx, Darty, Easyjet, Greencore, Hargreaves Lansdown, Howden Joinery, Int Cons Air, JD Sports, NMC Health, Ocado, Optimal Payments, PureCircle, Regus, Supergroup, Ted Baker, Thos Cook, Trinity Mirror, Xaar.

Negative momentum (the biggest fallers in the last 12 months): African Barrick, African Minerals, Anglo American, Antofagasta, Debenhams, Essar Energy, Evraz, First, Fresnillo, Hochschild, Kazakhmys, Kenmare, Ophir Energy, Perform, Petrofac, Polymetal, Randgold, RSA, Spirent, Tullow.

Note: Portfolios are drawn from IC stock screens, for UK shares with a market cap of over £500m