This article draws heavily on a note first published by Chris Ng in the National Post, titled Sticking to the Rules; edits have been made throughout to bring the content into the South African setting.

WHY RULES MATTER

The evidence from the world of investment finance points to a number of straightforward, but important, results for investors. First, most fund managers fail to beat the index. Second, most investors do even worse than this because they trade fund managers and try to time the market. However, and third, by contrast, simple rule-based systems offer us the potential to produce results that are superior to the market index (which in itself is an example of a rule-based system – big companies are in the index, small companies are out).

Nonetheless, many investors still yield to psychological biases, such as chasing hot ideas and following herds as they pursue portfolio performance. In so doing, investors ride roughshod over the elegant, yet powerful, solution presented by simple rules-based systems. Yet, if they recognise the above-listed downfalls and acknowledge the potential of rule-based systems, investors can step off the treadmill of underperformance.

Followers of my fund management business, Cannon Asset Managers, will know that our investment process places great emphasis on the utilisation of rules in stock selection and portfolio. For instance, the large-cap fund that we run, the Cannon Core Companies Fund, has a set of clearly-defined rules that guide stock selection. By way of example, the portfolio is built out of companies found in the ALSI40 index; and our process gives predetermined weights to a set of value factors that include relative price-earnings valuations, price-to-book multiples, cashflow multiples and balance sheet strength and quality.

These criteria create the basis for stock selection. Specifically, stocks that meet the rules we lay down for identifying “great companies at great prices” are included in the portfolio. Stocks that do not meet the selection rules are excluded. Another related rule that we apply in portfolio construction is that all stocks must be held in sufficient weight to produce “alpha”. There is no such thing as an “underweight” position in our portfolio. If our rules-based process does not identify a stock as attractive, we zero weight the stock. Additional rules help further refine the investment process – a key strength in a world in which superior performance is hard to come by.

THE FAILURE OF FUND MANAGERS

But back to Chris Ng’s article. In Sticking to the Rules, Ng notes that it is well known that 80 percent of active money managers fail to outperform the market index – regardless of whether it is the S&P 500, the Nikkei or the ALSI. Eighty percent of the best and brightest in the industry of investment management, the MBAs the PhDs and the CFAs, are not able to beat the simple index.

So what exactly is a market index and why does it handily beat most of the active money managers? The S&P 500 is a universally recognised equity index that is a simple rule-based investment system. The top 500 companies by market capitalisation are in the index. If a company falls out of the top 500 in size, it is sold and another is purchased in its place. It is simply managed, consistent and void of the human emotions that influence the market: fear and greed. As investors, we are often our own worst enemy.

THE FAILURE OF INVESTORS

Peter Lynch managed one of Fidelity's most successful mutual funds over a 15-year period, achieving an annual return of approximately 30 percent. Despite this amazing record, he has said that many investors in his fund actually lost money. How can this be for a fund that returned an average of 30 percent annually? Quite simply, people jumped in and out of his fund at exactly the wrong times. Many investors, even professionals, too often are controlled by the emotions of fear and greed.

SIMPLE RULE-BASED SYSTEMS: SUCCESSFUL, BUT HARD TO FOLLOW

History shows that a simple rule-based investing system beats the vast majority of money managers. Rules make us consistent investors in good markets and bad markets, when we apply the principles consistently without paying attention to our emotions.

If it is hard for a professional to hang on to investing rules and principles, it is twice as difficult for the amateur investor. Almost 25 years ago, two very successful professional equity market participants, Richard Dennis and William Eckhardt, made a bet as to whether ordinary people could be taught to trade professionally. The general consensus is that Dennis won the bet because, after teaching their trading system to a selected group of non-professionals, many ordinary folk from all walks of life began to trade successfully and many went on to become professionals. Dennis called his students "Turtles."

Curtis Faith, one of the original Turtles, recently wrote a book, titled Way of the Turtle, about the experience and it is interesting to note that he actually believes that the bet ended in a tie. In his mind, there were many Turtles who did not succeed. Turtle trading is a relatively simple, mechanical, rule-based trend following system. So how come some succeeded and others failed, when they were all taught the same rules and mechanics of the system?

SYSTEMS DON’T FAIL, HUMANS DO

Curtis noted that many students who failed fought the system. Some of the Turtles even believed that the successful ones were favoured with secret information. The truth was simpler than that. Some were just not able to execute the system. For whatever reason, either by adding their own beliefs and logic or by trying to out-think the system, some students just could not execute a mechanical system.

We can compare what happened with the Turtle traders to a mechanical system based on value investing, such as the Dogs of the Dow, or Ben Graham's net asset formula. Warren Buffet has said that the concept of value investing is easy but the execution is hard to do. Mechanical systems and rules help control emotions which have been shown to hinder many investors, especially amateurs.

WHAT HAPPENS IF WE STICK TO THE RULES?

The question is, how many investors are using mechanical rules and what is preventing more of us from doing so? There are many proven mechanical systems, but few are ever adopted by the general public. One of the most famous is the Dogs of the Dow. Pick the 10 highest-yielding, dividend-paying companies on the Dow Jones industrial index and rebalance once a year. The long-term record of the Dogs of the Dow is excellent. It has outperformed the DJIA in every decade, except the 1930s and the 1990s. Both were unusual decades, particularly the 1990s with the dot-com frenzy. Still, the Dogs of the Dow would have protected you through the subsequent bear market.

WHY SO MANY FAIL

One of the difficulties is that, as investors, we tend to chase the hottest and latest thing. As a group we are rather impatient, and with a couple of years of underperformance, we head for the exits - sometimes only after a couple of months. That is why so many investors lost money on Peter Lynch's fund. Sometimes it takes years for a mechanical system to prove its long-term market-beating ability. But rarely do we sit through the lean times. Investors are far more likely to switch systems at exactly the wrong time.

There is also the issue of ego. Given a mechanical system, most of us immediately feel we can improve it with our own input. All you need to do is look at the chat on investment sites. Formulas and rules are often viewed as starting points, but given our own input, surely we can improve on the performance. The result is that a mechanical formula is rarely executed in its original form. This is the reason many of the Turtles failed.

Finally, for most there is no fun in executing a mechanical system. Most investors enjoy the challenge of matching wits with the market. The exhilaration of being proven right after hours of analysis is the high that most investors crave.

BUT WAIT, THERE’S MORE

However, if we are able to engage a rules-based system, and to stick to the system with discipline and dedication, then we bring into the frame an ability to overcome some of the most basic – yet most detrimental – errors that are made in portfolio management. In turn, by stripping out these errors, we establish the platform to produce investment results that are in the top quintile of results produced by investment professionals and, by implication, ahead of the market.

Examples of such successes given above include the Dogs of the Dow – a simple system that focuses on dividend yield amongst the thirty stocks that make up the DJIA. However, other cases are to be found. In South Africa, as part of Cannon Asset Managers’ investment team, I have been involved in a decade-long study, titled Diamonds and Dogs. The results of the study are compelling: a simple rule that uses one factor – the price earnings ratio – to select industrial and financial stocks, has allowed for the creation of a portfolio that produced returns five times greater than the market over the period 1996-2007. Surprisingly, this result was produced with no significant difference in risk, with the rules-based value portfolio has performed with a high rate of consistency, beating the market in nine years of the past 12 years.