A little math that changed the world..
In 2002, Billy Beane, manager of the Oakland A's, revolutionized the game of baseball by using mass statistics in a new way called sabermetrics. Prior to that, managers would hire new players based off many different variables. Scouts played a major role in this process, compiling reports on prospective players. But the truth was that these reports were highly subjective, and could be incredibly flawed.
Billy Beane realized that this way of playing was out of date. He shifted the team’s focus to the only statistic that matters at the end of each game: how many runs did they score? Each player’s statistics was compared to how well it helped the team achieve this goal. And just like that, Billy Beane had revolutionized Baseball.
Photo by Bill Stephan on Unsplash
What’s that have to do with investing?
In the world of investing, people would buy and sell based on the advice of brokers (the investing equivalent of the baseball scouts). Investors here faced the same issues that Billy Beane saw so prevalent in baseball. Brokers’ picks were subjective and based on incomplete data.
Unfortunately, investors constantly needed a way to beat the average return of the market, and this seemed to be the only way. And so, investors would try to analyze a seemingly endless list of variables to decide whether a given stock was desirable. Price-to-earnings, charting data, and more subjective factors like personnel could all play a role in making these decisions.
Then two men, Eugene Fama and Kenneth French, made a groundbreaking discovery.
Just like sabermetrics cut through unnecessary variables, Fama and French realized that historically, only a few variables, or factors, truly gave investors the ability to get better returns than the market, and in such a way that they could consistently make a profit.
Suddenly, the endless stream of analysis from television shows and the internet became obsolete. Fama and French had changed the whole ball game.
If it’s so great, why doesn’t everybody do this?
When Billy Beane first introduced the idea of using math and statistics to choose players and manage his team, a lot of people argued against him. Even when his team started to win (even getting a 20-game winning streak at one point), people were slow to adopt his new method.
Similarly, even though the theories behind Factor Based Investing have won Nobel prizes (Modern Portfolio Theory in 1990, and Efficient Market Hypothesis in 2013), people have been slow to let go of the way trading has been done for centuries.
This is great news for ordinary people, such as yourself. By taking advantage of this mathematically based investing strategy, you can get a competitive edge over others who rely on luck.
So the next time someone tells you they have a stock pick that they’re sure will go up, think back to Billy Beane and his Oakland As. Don’t use the outdated way of playing. Lean on the science of modern investing instead.
If you’re interested in learning more about Factor Based Investing or developing a portfolio for yourself, sign up for a free Bronze Account today!