Along with helping us develop guidelines for running the soon-to-be Workshop Portfolio, the community has helped us refine the mix of strategies chosen. A tweak to the mix reduced the number of strategies and stocks we need to hold to achieve diversity and a good return/risk ratio while lowering commission costs.
(If you are new to this area or just checking back in with the Foolish Four because it's time to renew your portfolio, we are talking about the process of selecting mechanical strategies for an expanded portfolio that will include several new strategies developed by the Workshop community. You will need to catch up by reading at least: Farewell, Foolish Four and Introducing the Workshop Portfolio. )
Since we greatly respect the consensus thinking of our community -- indeed these comments were exactly what we were hoping for -- we tweaked the blend. By changing the PEG screen in the original mix from PEG-26 quarterly to PEG-13 monthly we were able to drop the monthly RS-13 screen which simplified things a bit.
More importantly, the backtested returns for the simpler version were much better. After all, the point of using multiple strategies was to improve the returns while lowering volatility and paying as little as possible in commissions. But then last week, Todd Beaird took a look at how the remaining five strategies interacted. He compared the risk-adjusted returns (using the Sharpe Ratio, a measure of return per unit of risk) for each screen with the Sharpe Ratio for screen blends.
(Anyone who missed Todd's Workshop articles last week and this week and who is planning to do any mechanical investing should make an effort to read them both. They are vital to understanding the mechanical investing process and evaluating the risks of mechanical investing.)
When we looked at how the Sharpe ratio changed as we added screens to our mix, we found that the ratio went up with one exception: KeyEPS. When KeyEPS was added, the Sharpe Ratio went down which led us to question whether KeyEPS should be in the portfolio at all. If we are going strictly by the numbers, we should drop it.
Todd turned that question over to the community and a fascinating discussion ensued. The consensus was that the small decrease we saw in the Sharpe ratio was "in the noise level" but that the additional diversity that KeyEPS brought to the portfolio was quite real, therefore, KeyEPS was worth keeping. The thread starts here and I highly recommend reading it, even though I've already given you the answer from the back of the book.
The discussion ranges way beyond the question of the KeyEPS and touches on concepts such as the Efficient Frontier, Modern Portfolio Theory and the Capital Market Line as ways of finding the best possible portfolio blend. If you've ever wondered why I am so eager to turn some of my money over to the guidance of a bunch of people I "met in a chat room" this thread should answer that question.
Next week will be the last week for the Foolish Four area. We will be combining the Foolish Four and the Workshop starting on Tuesday, January 2. We will also be adding an additional column per week to run on Friday. The general schedule will have Todd writing a "sophisticated-investor" level column on Tuesdays, the community "writing" the Thursday column (it will highlight the best posts from the discussion board), and me writing a perpetual "Welcome to the Workshop"-type column on Fridays. So now you know which day(s) to skip! All of the Foolish Four background material will be given a permanent home in the Workshop, and the Foolish Four portfolio will be merged into the new Workshop portfolio.
A word about that may be in order. Adding Workshop strategies to the Foolish Four portfolio means that the Workshop Portfolio will start out with the Foolish Four's rather dismal returns for the last two years. We could have killed the Foolish Four portfolio and started the Workshop portfolio from scratch with a fresh Foolish Four component. There are a lot of good reasons to start from scratch, but it felt wrong. It felt like we would be trying to hide something, sweep the performance of the past two years under the rug.
So we are stuck with the Foolish Four's history. In a fairly short time, the greater weight of the new strategies will overwhelm the Foolish Four's past, so I'm not terribly concerned, but this means that the total return and annualized return for the Workshop portfolio will be somewhat skewed for a while. Tomorrow I will write a bit more about why we are keeping the Foolish Four in the portfolio.
If anyone is too terribly upset about Foolish Four baggage making mechanical investing look bad, it might be a good idea to contemplate how our new portfolio might look right now if we had started it last January. We have to learn to live with the ups and downs. This year has been highly educational!
Fool on and prosper!