Monday, December 15, 2014

Davis, Being Right or Making Money

Ned Davis started his eponymous investment research company in 1980. Thirty-four years later NDR employs nearly 50 researchers and has a client base of more than 1,200. It is widely respected for its objective analysis and its timing models.

The third edition of Being Right or Making Money (Wiley, 2014) showcases the firm’s guiding principles and some of its research. Although I have neither the first (1991) nor the second (2000) edition of this book, I think we can safely discard the idea that the 2014 edition is merely an update. The simple fact that the second edition was 150 pages long and the new edition runs some 231 pages is probably sufficient to disavow anyone of that notion. Chapters that deal with current topics, such as a potential bear market in 2014 and the game-changing nature of U.S. energy independence, are another tip-off.

What has remained the linchpin of all three editions is Ned Davis’s own investment philosophy. Even here there has been one major change: “the evolution of my belief that the most successful money managers are risk averse.” (p. xv)

Davis maintains that the four keys to making money in a business characterized by making mistakes are objective indicators, discipline, flexibility, and risk management. There is, of course, a dynamic tension between discipline (“remaining faithful to [one’s] systems through good and bad times”) and flexibility (the ability to change one’s mind when the evidence shifts). Davis readily admits that “there are periods, historically, in which model indicators tend to fail or stay wrong against a major move.” (p. 35) Risk management-–in the simplest terms, being willing to take small losses but avoiding big losses—helps to resolve this tension. And hence “the bottom line at Ned Davis Research is that our timing models, at every stage of development, are designed with one thought foremost in mind, and that is controlling big mistakes.” (p. 36)

Three chapters of this book are devoted to model building. The first describes the process of model building; the next two offer a stock market model and a simple model for bonds.

In building a timing model, the investor should first make sure he has clean data. He must then investigate “which data series, out of the innumerable possible sets out there, are the most useful or relevant for asset-allocation and market-timing purposes. Some data is best suited for aggressive, short-term trading, while other data is best suited for long-term asset allocation and risk control. Finding out what is useful is the biggest challenge the investor faces….” (p. 42)

NDR employs both internal and external indicators in its timing models. Internal indicators include such things as the slope of a moving average, breadth-thrust, and momentum. External indicators include interest rates as well as sentiment and valuation. Numerous charts illustrate indicators NDR has found useful in its models.

The final three chapters of the book—the first by Ned Davis, the second by Alejandra Grindal, and the final one by John LaForge—are examples of the kind of research NDR does. They are chock full of graphs, some comparing data that might not seem to be obviously connected such as the U.S. petroleum trade deficit and the goods deficit with China.

Being Right or Making Money is a tribute to the kind of research that can help the investor make money, even if he’s not always right.

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