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Workshop Portfolio The Sum of the Parts
Can be less than the whole

By Todd Beaird (TMF Synchronicity) (Synchronicity)

DES PLAINES, IL (Dec. 14, 1999) -- The return of a balanced portfolio of five stocks can be higher over time than investing simply in the highest-returning position. In other words, the average can be higher than any of its individual components. If this sounds impossible, think again.

Take one of our top screens, PEG. Here are the compounded annual growth rates (CAGRs) for "slots" one through five of the PEG screen. A slot is the rank of each stock as determined by the PEG screening technique. The compound annual growth rate is shown for a 12-month holding period, and the returns are averaged across all starting months. (All data was gathered from Jamie Gritton's backtest website.)

Stock     PEG5  
1        14.41%     
2        25.87%   
3        26.18%    
4        12.43%     
5        16.40%    
You will note that, surprisingly, the top spot has underperformed numbers two and three, and positions one, four, and five failed to beat the market during the backtested period.

Now, imagine someone who wanted to cherry-pick a good stock from a good screen. He decides to invest only in the stock that is in position three of the PEG screen each year. As we can see, such a strategy would have averaged around 26% per year from 1986 through 1998. (This is actually the mean average return for 12 one-stock portfolios -- one that renews each January, one renewing each February, et. al.) Not bad.

But compare that with the historical returns for a five-stock PEG portfolio. The average return under identical circumstances was 30.2%. (Please note that these may vary slightly from the results from Elan Caspi's recent article.)

That's right. A five-stock PEG strategy has a higher annual return than any one of the top five slots on their own.

You're probably asking how this could happen. Here's a quick example. Take a five-stock screen. In the first year, slot 1 goes up 100%, slot 2 goes down 50%, slot 3 goes up 50%, slot 4 stays even, and slot 5 goes up 25%. If you started with $1,000 in each stock, at the end of the year you'd have:
Slot 1    Slot 2    Slot 3    Slot 4    Slot 5  Total Year 1   
$2,000    $500     $1,500     $1,000    $1,250    $6,250

This works out to a total return of 25% for the year.

You then rebalance, and put $1,250 in each slot. In the second year, slot 1 goes down 25%, slot 2 goes up 100%, slot 3 stays even, slot 4 goes up 50%, and slot 5 stays even. At the end of the year, you'd have:
Slot 1    Slot 2    Slot 3    Slot 4   Slot 5   Total Year 2   
$937.50   $2,500    $1,250    $1,875   $1,250    $7,812.50
And again, you'd have a return for the screen of 25%, and you would have an enviable total two-year return of 56.25%.

Now, instead, imagine if you had five different people, each investing in one "slot" from the PEG screen. Adam invests in PEG#1 each year (he runs the PEG screen, takes the top-ranking stock, and invests his entire amount in that one stock). Basil invests in PEG#2, Christine in PEG#3, Doris in PEG#4, and Eddie in PEG#5. Here are what their returns would have looked like after two years.
Adam      =$1,000*2.0*0.75=$1,500    CAGR=22.5% 
Basil     =$1,000*0.5*2.0 =$1,000    CAGR=0.0% 
Christine =$1,000*1.5*1.0 =$1,500    CAGR=22.5% 
Doris     =$1,000*1.5*1.0 =$1,500    CAGR=22.5% 
Eddie     =$1,000*1.25*1.0=$1,250    CAGR=11.8%
At the end of two years, if they all got together and pooled their funds, they
would have: $1,500+$1,000+$1,500+$1,500+$1,250= $6,750, for a total, two-year return of 35% and a CAGR of just 16% per year.

So, when you get together with Adam and the rest of the group two years later, you'll have over a thousand more dollars than their total, even though you invested the same amount of money in the same stocks that they did. The only difference was that your stocks were part of a balanced, five-stock portfolio, while they each invested in just one stock.

The same effect would be seen if an individual investor decided not to rebalance his portfolio each year, but instead invested in each new stock the proceeds from the sale of the stock that was in the same slot the previous year. And it wouldn't help much if Eddit and Basil had been in slot 3 with Christine. You would still have beaten them.

How is this happening? Each year some slots do well, and some not so well, but overall the screen has very good returns. Rebalancing each year prevents a drop in any one stock from ruining our returns, while allowing the gains to compound in the other positions. For at least some of our screens, the whole is greater than the sum of its parts.

Next week I'll have an in-depth look at the backtested returns on most of our screens. Until then, Fool on!

Help make the world a better place -- contribute to Foolanthropy!

Workshop Portfolio


9/28/01 as of ~5:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AETAETNA INC NEW0.943.36%28.94
BABOEING CO(1.04)(3.02%)33.36
CATCATERPILLAR INC1.112.53%44.91
COGCABOT OIL & GAS 'A'0.693.59%19.90
DDDU PONT (EI) DE NEMOURS0.992.74%37.14
DGXQUEST DIAGNOSTICS(0.45)(0.73%)61.42
EKEASTMAN KODAK0.421.31%32.49
GMGENERAL MOTORS1.393.38%42.55
LHLABORATORY CORP AMER HLDG(NEW)1.141.42%81.21
MOPHILIP MORRIS COS(0.76)(1.55%)48.24
NEWPNEWPORT CORP0.261.90%13.97
NVRNVR INC(0.54)(0.38%)140.41
PKXPOHANG IRON & STEEL ADS1.097.51%15.61
PVNPROVIDIAN FINANCIAL1.075.64%20.04
QCOMQUALCOMM INC(0.40)(0.84%)47.16
RJRRJ REYNOLDS TOBACCO HLDGS(0.69)(1.19%)57.31
SLESARA LEE CORPUnchg.Unchg.21.09
UNFIUNITED NATURAL FOODS0.563.18%18.15
WMIWASTE MANAGEMENT(0.01)(0.04%)26.74

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(12/24/1998)
Workshop1.30%7.32%(12.02%)(20.66%)(18.91%)
Comparable S&P 500n/an/an/an/a(19.07%)
S&P 500 (DA)1.95%7.48%(8.33%)(21.22%)(14.88%)
NASDAQ2.02%4.71%(17.46%)(39.68%)(31.41%)
DJIA (DA)1.68%7.07%(11.07%)(17.86%)(2.22%)

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (12/24/1998)
Workshop(17.62%)
vs. S&P 500(17.63%)

Trade Date # Shares Ticker Cost/Share Price Total % Ret
1/8/0126MO40.9448.2417.82%
1/8/0122RJR50.1057.3114.39%
1/8/0167UNFI16.4518.1510.34%
12/24/9824CAT43.0844.914.24%
1/8/018NVR136.63140.412.77%
1/8/0140WMI27.4426.74(2.54%)
1/8/0150SLE22.5421.09(6.42%)
1/8/0161PKX17.8315.61(12.46%)
1/8/0115DD48.8337.14(23.95%)
1/8/0129AET38.1728.94(24.19%)
1/8/0139COG28.7519.90(30.79%)
1/8/0114QCOM75.5447.16(37.57%)
1/8/018LH134.6981.21(39.70%)
12/27/9918GM73.2642.55(41.92%)
1/8/0118BA59.5333.36(43.96%)
1/8/019DGX114.4961.42(46.35%)
12/27/9920EK65.0932.49(50.08%)
1/8/0120PVN55.5020.04(63.89%)
1/8/0115NEWP74.9613.97(81.36%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
1/8/0126MO$1,064.50$1,254.24$189.74
1/8/0122RJR$1,102.25$1,260.82$158.57
1/8/0167UNFI$1,102.12$1,216.05$113.93
12/24/9824CAT$1,034.00$1,077.84$43.84
1/8/018NVR$1,093.00$1,123.28$30.28
1/8/0140WMI$1,097.50$1,069.60($27.90)
1/8/0150SLE$1,126.88$1,054.50($72.38)
1/8/0161PKX$1,087.75$952.21($135.54)
1/8/0115DD$732.50$557.10($175.40)
1/8/0129AET$1,107.00$839.26($267.74)
1/8/0139COG$1,121.37$776.10($345.28)
1/8/0114QCOM$1,057.62$660.24($397.39)
1/8/018LH$1,077.50$649.68($427.82)
1/8/0118BA$1,071.50$600.48($471.02)
1/8/019DGX$1,030.44$552.78($477.66)
12/27/9918GM$1,318.62$765.90($552.73)
12/27/9920EK$1,301.75$649.80($651.95)
1/8/0120PVN$1,110.00$400.80($709.20)
1/8/0115NEWP$1,124.37$209.55($914.83)
 
Cash: 
Total: 
$10.80
$15,681.03
 

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.
• DJIA (DA) = dividend adjusted. Dividends have been added to the total return of the DJIA.

Note
Note: The Workshop Portfolio was launched on December 24, 1998, with $4,000 which was invested in the Foolish Four strategy. Approximately $15,000 was added on January 8, 2001, to support five additional mechanical strategies. At that time approximately $1000 was transfered out of the Foolish Four strategy to bring the Foolish Four into balance with the other strategies. (That's why the Foolish Four's overall return is not consistent with stock values.) Such rebalancing will take place each year among the strategies so that each will start out with approximately the same value at the begining of the year. No more cash additions are planned. The first four tables above show the overall performance of the portfolio. Below that we also track the performance of each component strategy. All transactions are announced publicly before being made, and returns are compared daily to the S&P 500 and the Dow. (Dividends are included in the yearly, historic and annualized returns.) Stocks are chosen using strategies developed by the Workshop community.


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