To see what I mean, consider commodity prices. History suggests that these are not entirely unpredictable. We have a lead indictor of them. In recent years, annual changes in the Chinese M1 money stock had led - with a lag of a few months - to changes in commodity prices. This is simply because M1 predicts Chinese output growth, which in turn is a big determinant of commodity prices.
With M1 growth having accelerated recently, this relationship points to a recovery in commodity prices around the middle of this year. Investors in mining stocks therefore have a reason for optimism.
Chinese M1 growth & commodity prices
Except for one thing. Life is lived during time lags. The months between M1 accelerating and commodities rising can be painful for mining investors. Not only can they suffer big losses before commodity prices turn around, but they also suffer weeks of doubting (perhaps reasonably) whether past relationships will continue to hold.
What we have here is what Cliff Asness at AQR Capital Management has called time dilation: time looks very different to a researcher than to an investor. To a researcher, a time lag of a few months can be part of a robust historical relationship. To an investor, it can be agony to live through.
This difference in perspective is unavoidable. Profitable patterns - be they leading indicators or stock-picking strategies - can only be found in long runs of data. Day-to-day moves are mostly noise, which the researcher looks through. However, real-life investors, living from day-to-day, suffer the noise.
Mr Asness gives another example of time dilation. To a researcher, a strategy that has given good long-term risk-adjusted returns looks fantastic. An investor who uses that same strategy, however, might suffer months of discomfort simply because even the best strategies can underperform for long periods. For example, in recent years defensive stocks have comfortably beaten the market: our no-thought defensive portfolio has risen over 50 per cent in the last 10 years against the FTSE 350's 12 per cent. Sounds great? But during this time, defensives underperformed for two years, between 2009 and 2011. That's an uncomfortably long time for an investor.
Long enough, in fact, to get a fund manager sacked. Compare the fates of Warren Buffett and the late Tony Dye in the late 1990s. Both knew that big dividend-paying stocks had generally outperformed for long periods. And both suffered horrible underperformance as such stocks fell out of favour during the tech bubble. There, though, the similarities end. Mr Dye was sacked but Mr Buffett wasn't, and his fortune soared when historic patterns reasserted themselves and dividend-payers came back into favour. Mr Dye was a loser from time dilation, Mr Buffett a winner.
All this might help explain what is otherwise a paradox. On the one hand, we know that there are a few strategies that beat the market over long periods: defensives, momentum, value and quality. On the other hand, very few fund managers actually do outperform.
One reason for this might be that time dilation stops investors putting research into practice. Fund managers can't back momentum or defensives for fear that longish periods of relative underperformance might get them sacked. Instead, they dilute such strategies with other stocks causing their funds to behave like tracker funds. In this way, they reduce the risk of being sacked at the expense of reducing returns to mediocrity.
Herein lies an opportunity for retail investors. Like Mr Buffett, we are in the happy position of not facing the sack if we underperform. We can, therefore, stick to what works over the long term.
This, however, is easier said than done. There's a danger we'll get disheartened by temporary underperformance and throw in the towel, perhaps selling at the worst time. This isn't wholly to be condemned; there's a thin line between the man who has the courage to stick to a plan and the bigot who is immune to evidence.
The point here is that the obstacles to being a successful investor are not so much intellectual as psychological. We know what works. Doing it is another matter.
