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From the Money Managers: O’Shaughnessy Update

James O’Shaughnessy, author of What Works on Wall Street, recently wrote an article in the CFA Institute Quarterly Journal that reviewed the major themes from his 1996 book. For those who have not read O’Shaughnessy’s book, it is based on research covering the period from 31 December 1963 to 31 December 1995. His goal in doing research for his book was to determine if specific traits held up as good stock-selection mechanisms over long periods of time. He found that a lot of academic research had been done on this subject, but the time periods studied were very short. At the time of his research, he found a large body of academic work suggesting that a bunch of monkeys throwing darts at the Wall Street Journal could pick stocks as well as any professional money manager because the stock market is efficient. Being a professional money manager, he was not flattered by the comparison. Nevertheless, it was difficult to refute the studies that showed in any 10- year period roughly 80 percent of conventionally managed portfolios failed to beat the S&P 500. O’Shaughnessy tested portfolios based on various value and growth factors and concluded that the market consistently and methodically rewards certain attributes while it punishes others quite severely. Of interest to the Dorsey Wright crowd is that O’Shaughnessy noted that “relative strength is one of the criteria in all 10 of the top-performing strategies, proving the maxim that you should never fight the tape.” He pointed out that the worst strategy he tested was the anti-relative strength strategy of bottom fishing and buying the 50 stocks with the worst one-year price performance.

O’Shaughnessy recently updated his study through 31 December 2005. Interestingly, 10 years after his original study was published, every strategy that was shown to be the best in 1996 has continued to be the best. With the book in wide circulation since 1996, that should not have happened. In an efficient market, the advantages associated with the strategies should have been arbitraged away. The answer to why these strategies continue to work is found in behavioral finance. Strategies such as relative strength continue to work because human psychology does not change. Proponents of efficient markets should study why investors consistently commit the same errors in decision making. Several theories in behavioral economics help explain investor behavior: prospect theory, myopic loss aversion and narrow framing, fear of regret, and hindsight bias. Prospect theory says that investors are risk seeking for losses but risk averse for gains and that most investors hate losses so much that they hold their losing stocks and sell their winners (the exact opposite of what a relative strength strategy forces you to do).

O’Shaughnessy points out that “as investment professionals, we like to think that what we do is quite glamorous. It is not. Anyone who can do basic arithmetic and stick to an underlying discipline has the makings of a great portfolio manager. I often think of Woody Allen’s quip: ’80 percent of success is just showing up.’ Well, 99 percent of investment success is just diligently following an investment strategy through all the ups and downs of the market.” That quote should probably be hanging on your wall.

Dorsey Wright’s Money Management division is based in Southern California. To learn more about the different relative strength-based accounts that we offer please give us a call at 626-535-0630. Or, click here, to receive our brochure.

Finding Value in Growth

The volatility in the markets over the past couple of months has made investors become increasing nervous to say the least, and in times of uncertainty they turn to you, the advisor, for calming words of guidance. We discussed in Friday’s report some talking points that are apropos in this market, and many other additional observations that we have been seeing amongst our indicators for the equity market. In perusing the mutual fund indicators I have been noticing something quite interesting. An indicator that we look at for mutual fund asset classes is the Percent of Funds within the group that have positive relative strength against the overall market. That is, those funds that are on relative strength buy signals versus the S&P 500 Equal Weighted Index. In mid


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