Bump the Bell Curve
In any competitive environment, whether it’s baseball or financial markets, our first instinct is to identify the few top performers.
However, Longboard’s research shows that for investments to win over the long term, it’s more efficient to strategically avoid the many underperformers. To do that successfully, you need a bit of background.
Navigating the competition gap
In most competitive situations, “performance” is a measure of success. Talented athletes score more, good students test well and skilled investors generate strong returns.
Traditionally, statisticians have used the normal distribution, or “bell curve,” to study the range of performance. Such analysis assumes that most performance clusters around a central, average value and extreme underperformance and outperformance are rare.
However, looking deeper, the bell curve theory loses its luster. According to a statistical theory called the Pareto Principle, normal distribution of performance is rare in real life.
Why? Because when individuals compete, a small minority performs more efficiently than the majority. These few accumulate a disproportionate amount of the total rewards, creating a “fat tail” distribution of extreme outperformers and underperformers with a large gap — the “competition gap” — between them.
Fat tails, and the resulting competition gap, occur naturally and persistently in every competitive environment, including financial markets.
How trend followers play the game
Because this extreme performance is persistent across financial markets over time, it’s possible to navigate through the competition gap with long-term trend following.
If a small minority of investments performs more efficiently than the majority, which is a more effective use of time and money over the long term?
- Pursue the ever-changing minority of outperformers
- Proactively and consistently trim underperformers
Chasing the potential high performers takes time and money — and since few investments do outperform the overall market, investors could still end up on the unprofitable side of a sustained downtrend.
That’s why trend followers approach the competition defensively. They constantly prune their portfolios, trimming failing investments instead of chasing the smaller fat tail of exceptional performers.
Keep the best, cut the rest
Taking a long-term view of the market enables trend followers to spot early indicators of downtrends and eliminate those positions before they cause significant damage to a portfolio. This approach can potentially deliver downside protection.
Of course, an additional benefit to this defensive positioning is the ability to naturally gravitate more of the portfolio toward the fat tail of exceptional — and potentially more profitable — performers, adjusting as trends dictate.
What’s more, alternative investment strategies that focus on trimming long-term underperformers can add further diversification—potentially delivering results that are uncorrelated to the market and to other alternatives.
Investors can access these unique sources of non-correlation in longstanding financial markets, such as stocks, as we explore further in our signature research.