At the same time you have to be on guard against apophenia, seeing connections where none exist. Unless such things make you smile. First up, Psychology Today:
Being Amused by Apophenia
You experience the following on a Monday: The alarm clock does not wake you up and you are now late for work. The cat has peed on the couch. The coffeemaker is making strange noises and doesn't seem to be working. The kids are fighting with each other. It's raining. And on top of everything else, the car won't start. What do you conclude? One or two of these minor irritants would seem insignificant and unmemorable. Once the list grows, however, it begins to take the shape of a plot—a plot of unseen forces perhaps conspiring in a meaningful way against you.And today's headliner, from the CFA Institute:
Our brains are pattern-detection machines that connect the dots, making it possible to uncover meaningful relationships among the barrage of sensory input we face. Without such meaning-making, we would be unable to make predictions about survival and reproduction. The natural and interpersonal world around us would be too chaotic. In the above example, if I draw conspiratorial conclusions (i.e., seeing a pattern where none really exists), I am making what statisticians would call, a Type I error, also called a false positive.
What if you experience the following upon entering your house alone at night: The front door is left open. Household objects are strewn everywhere (you left the house neat and clean just a few hours ago). Your computer is missing. There are faint but unrecognizable smells. You can hear someone talking. In all likelihood, we would not only draw conclusions about has occurred but we will have a palpable, physiological response as well. Nature ensures that we are prone to seeing patterns rather than missing them. The Type II error, seeing no pattern where a pattern exists, turns out to be more dangerous. Far better—from a Darwinian perspective—to erroneously interpret danger where none is present than miss out on important cues that put our survival on the line. There is cognitive efficiency built into this equation: quick reactions depend on a cost-benefit ratio that favors safety and survival....MORE
It’s no secret that consistently generating alpha is extremely difficult. Today’s asset allocators and portfolio managers are constantly seeking new strategies to gain any sort of advantage. What if achieving an edge were as easy as an all-in, binary decision depending on whether one particular industry over- or underperformed the stock market? Any believer in the efficient market hypothesis would claim this approach impossible because share prices always incorporate and reflect all relevant information. Moreover, given the enormous wealth of available information, how could examining only one sector’s performance distill sufficient evidence to determine an entire asset allocation strategy?
CFA Institute recently hosted a webinar titled, “Generating Alpha: Predicting Volatility and Corrections,” which focused on a branch of technical analysis called intermarket analysis, or the study of relationships between asset classes and market sectors. The presentation by Charlie Bilello and Michael Gayed of Pension Partners was based on their award-winning papers, “An Intermarket Approach to Beta Rotation: The Strategy, Signal, and Power of Utilities” (which we previously profiled in “The Predictive Power of Utility Stocks“), and “An Intermarket Approach to Tactical Risk Rotation.”
Bilello and Gayed were inspired in part by the work of Edson Gould, who identified the Dow Jones Utilities Average (UTIL) as “one of the best early indicators of the stock market.” Building on Gould’s work, Bilello and Gayed backtested US stock market returns to 1926 and found that a simple strategy of rotating either fully into utility stocks or fully into the broad stock market based on rolling 4-week returns outperformed a buy and hold approach, on a risk-adjusted basis, by a wide margin. The so-called beta rotation strategy would more often than not be invested in the lower beta utilities sector when market conditions became more volatile and less favorable for stocks. While transaction costs would have rendered such a strategy prohibitively expensive over much of the time period tested, it can be cheaply replicated today (at least in nontaxable accounts) using ETFs. While not an appropriate strategy for everyone, Bilello and Gayed suggested that all portfolio managers might benefit from paying closer attention to what utility stocks are telling them....MORE
