What is Mechanical Investing?
by Todd Beaird ([email protected])
[Editor's note: This is the first article by one of the participants on Foolish Workshop message board. More are in the works from several outstanding contributors.]
Des Plaines, IL (May 27, 1999) -- If you're a newcomer to the Workshop Message board, you'll notice that we spend an awful lot of time "talking" about stock screens and mechanical investing strategies. You'll see comments like: "RS-IBD is up 73%," and "Does anyone still follow UG5 monthly?" and "How far back has Spark5 been tested?"
You might wonder what is going on, especially when you hear stories about strategies that have average annual returns of 40+% over the last decade. Forty-one percent per year compounded over ten years will turn one dollar into thirty (or $10,000 into over $300,000). That's why we spend so much time on stock screens.
What is a stock screen? A stock screen is a mechanical method of selecting stocks based on objective, quantifiable criteria. The Foolish Four is an example of a stock screen that all of you should be familiar with (if you're not, please click here).
Most stock screens have a selection process similar to the Foolish Four. Out of the 8,000-plus stocks publicly traded on major exchanges in the US, a screen narrows the list of possibilities by eliminating all stocks that do not meet certain criteria. Some of those criteria might be membership in the Dow, price appreciation of X% over the last 26 weeks, or earnings per share growing at X%.
Many of the Workshop screens use information from the publications Value Line and Investor's Business Daily to screen stocks. The stocks remaining after filtering out all those that don't meet the criteria are ranked according to a final factor, and the top 5 (or more, depending on the screen) are selected.
Stock screens are the backbone of mechanical investing strategies. When using such a strategy, stocks are selected according to an objective stock screen and are bought and held according to the rules of strategy. Most strategies require you to hold the stock for a set period of time (usually a year) before selling.
Why would anyone want to use a mechanical strategy? Why not just follow the Fool's example in the Rule Breaker and Rule Maker portfolios? They've done pretty darn well. How many stock screens would have found America Online (NYSE: AOL) or Amazon.com (Nasdaq: AMZN)?
Well, with apologies to the Siamese sitting in my lap as I type this, there's more than one way to skin a cat. Mechanical strategies offer certain advantages over "traditional" methods of choosing stocks.
First of all, you may not be as accomplished a stock-picker as the Gardners or Peter Lynch. Consider this: Index Funds are nothing more than a simple mechanical strategy. Stocks are purchased when they are added to the Standard & Poor's 500 Index and sold when they're dropped from the Index. It doesn't get much simpler than that, yet year in and year out, index funds do better than the vast majority of professional money managers who pick stocks for mutual funds.
Second, once you've decided on your strategy(s), running the screen that chooses the stocks to buy and sell takes very little time. The Foolish Four requires "only 15 minutes a year," and many of the Workshop screens take only a little longer. Even at an hour a month, that's a lot less time than you'd spend digging through the paper and scouring the Internet for the latest information on a company.
Third, using mechanical strategies requires discipline. Many new investors will buy and sell at the worst possible times based on emotional reactions to short-term dips and trends. Mechanical strategies don't care if you're in a panic because XYZ Co. has dropped 20%, or if you're tempted to lock in a profit because it's up 50%. They help give you the discipline to hold your stocks until the rules say it's time to sell.
Finally, because the stock screens are based on objective criteria, you can see how the strategy would have performed in the past. The process of creating this historical record is called backtesting and helps to determine if a strategy is likely to outperform the market in the future. Looking at historical returns focuses an investor on long-term performance.
Another advantage of backtesting is that one can look at the historical record and see how volatile a strategy is before deciding to follow it. Do the portfolios go up 80% some years but down 40% in other years, or is the range more like -5% to +30%?
Most new investors don't have the time, the data, or the statistical and financial knowledge to develop and test their own screens, so they look for screens developed by others. Before deciding to follow a mechanical strategy that claims "35% annual returns," here are some questions to ask about it:
How far back has the screen been backtested? (Ten years is the absolute minimum, 25+ years is preferable.)
Has the backtesting period included both bull (up) and bear (down) markets? Some screens beat the market in good times but are awful when the market turns sour.
Does the screen consistently outperform the market, or have most of its gains occurred in one or two years? A screen that "hits the jackpot" once or twice may have a great average return over a fairly short test period yet be nothing more than a statistical fluke.
[NOTE: The weekly Rising Margins column has been discontinued. However, both the Margins screen and the Estimates screen will continue to be published each week.]