A motorsailer may not be the fastest boat, but it has more than one way to keep moving.

That is the right way to think about many portfolios. The highest-returning strategy in a historical test is not necessarily the best strategy to own in real life, because the lived experience of a portfolio matters. A strategy that looks superior over the full period can still spend years looking broken, misguided, or needlessly conservative.

In my old newsletter research, I often compared two broad approaches: valuation and momentum. Value looks at underlying earnings and asks whether an asset or market is cheap, fair, or expensive relative to history. Momentum looks at price behavior and asks whether an asset or market is rising or falling. Both can be useful, but they tend to help at different times.

Momentum often looks best in a long-term test. A simple rule such as owning markets only when they are above a long-term moving average can do an impressive job of avoiding major drawdowns. It does this by staying with rising markets, even when they appear expensive, and then stepping aside when price trends break down.

That sounds simple, and in some ways it is. The difficulty is that momentum is not clairvoyance. It can lag at turning points. It can sell after a decline has already started. It can re-enter after a recovery is already underway. It can also get hit by sharp breaks that happen before the monthly signal has time to react.

Value has a different set of strengths and frustrations. A valuation discipline can reduce exposure when markets become expensive and add exposure when markets become cheap. This is often psychologically uncomfortable, because value tends to sell before the top and buy before the bottom. It can look timid while an expensive market keeps rising, and it can look early while a cheap market keeps falling.

This is where combining the two approaches becomes useful.

Value and momentum derive their returns from fundamentally different sources. One looks at underlying earnings; the other looks at price vectors. Especially when working with stocks and a cash or Treasury vehicle, it is prudent to diversify factors rather than depend entirely on a single rule.

The combination may have a lower historical return than the strongest standalone strategy, but that is not automatically a defect. A portfolio that gives up some theoretical upside while reducing the severity and timing of drawdowns can be much easier to hold. The owner of the portfolio is less likely to abandon the plan at the exact moment when discipline matters most.

That is the point of “diluting” a winning strategy. The goal is not to maximize the backtest. The goal is to build something that can survive contact with the real investor.

Take the difficult periods around the early-2000s bear market and the financial crisis. Momentum did a good job preserving capital while stocks suffered, but value also had moments when it recovered faster or held up differently. In other periods, value took the deeper hit while momentum stepped aside. The combination helped because the two disciplines were not failing in exactly the same way at exactly the same time.

That distinction matters. A portfolio can have a good long-term record and still be very hard to own. Every strategy eventually creates regret. A value investor regrets not owning enough of the popular growth market. A momentum investor regrets selling after a decline or buying back after a rebound. A diversified investor regrets not concentrating in whatever just worked best.

There is no way around this. Frustration is part of investing. The practical question is whether the frustration is tolerable enough that the investor can continue following the plan.

A good portfolio should be judged partly by its ability to keep its owner from making a disastrous behavioral mistake. If a slightly diluted strategy reduces the odds of abandonment, the dilution may be a feature rather than a flaw.

This is one reason Fortuna combines valuation, momentum, and broad diversification. We do not want portfolios that depend on a single signal, a single market, or a single macro forecast. Value and momentum each contain useful information, but neither deserves complete authority over a portfolio.

The best portfolio is rarely the one that wins every short-term comparison. More often, it is the one that gives the investor a reasonable chance of staying invested through the full cycle, including the stretches when the strategy is out of favor, uncomfortable, and easy to second-guess.

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Originally published by Michael Ritger, September, 2019. Republished by Fortuna Investors.

This material is for informational and educational purposes only and should not be construed as personalized investment advice. Investing involves risk, including the possible loss of principal. Past market behavior does not guarantee future results.

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