From Insight to Action: Knowing the Limits of Investment Models

If you’re an investor today, you’re likely swimming in opportunities. There’s no shortage of funds, factors, or financial innovations vying for a spot in your portfolio. But with so many options (and so much buzz), it can be hard to separate what’s truly valuable from what’s simply trending.

To decide what earns a seat in your portfolio, one of the most important things you can do is evaluate the reasoning behind an investment. This often starts by understanding the financial model it’s built on.

Understand the Model… and Its Limits

To illustrate, think of a weather forecast. Using data on current and past weather conditions, a meteorologist makes a number of assumptions and attempts to guess what the future weather will be. This model may help you decide whether to take an umbrella or a coat with you when you leave the house. However, anyone who has been caught in an unexpected rain shower without an umbrella can tell you that reality often behaves differently from the model.

In investment management, models are used to gain insights that can help inform investment decisions. Just like with weather forecasts, investment models rely on different inputs and assumptions. A model is only as good as its inputs. If the assumptions are flawed, the outputs can be misleading. But even when the assumptions are sound, you still need good judgment to apply them correctly.

That’s where the implementation of the strategy comes into play. Whether it’s an index fund with a simple structure or a complex quantitative strategy, the manager has to execute the idea. It’s not just about having a smart model; it’s about putting it into practice effectively and consistently.

When evaluating different investment approaches, understanding a manager’s ability to effectively test and implement ideas garnered from models into real-world applications is an important first step. Some strategies, such as traditional index funds, are fairly straightforward. You know what you’re getting, and it’s easy to track how well the fund is doing relative to its benchmark. These require relatively little trust. But with more complex or opaque strategies, the picture gets murkier. You may need to have faith that the manager is making good decisions, even when you can’t see under the hood. That’s not necessarily bad, but it does mean the bar for confidence should be higher.

Use Models as Tools, Not Truths

At the end of the day, models are just tools. They can help guide your decisions, but they shouldn’t make them for you. In the end, there is a difference between blindly following a model and using it

judiciously to guide your decisions. As investors, cutting through the noise around the “latest and greatest” investment products and identifying an approach that employs sound judgment and thoughtful implementation may increase the probability of having a positive investment experience. When considering a new investment, ask:

• What role will this play in my portfolio?
• What are the assumptions behind this strategy?
• How transparent is the process?
• How much do I need to trust the manager to get it right?

There’s no magic formula. But by staying grounded, asking the right questions, and applying sound judgment, you’ll be much better equipped to build a portfolio that truly works for you.