Workshop Portfolio Diversify Your Mechanical Strategies

By Moe Chernick
May 23, 2000

One difficulty many people have with the Workshop strategies is deciding which strategies to use. While it might be tempting to pick the screens with the best historic returns (or, if you're really short-sighted, last year's best returns), doing so may lead to disappointment. There are a number of reasons for this:

1. Past returns don't guarantee future performance. (This phrase has been used so much that you might be tempted to see it as just a cliché, but it is profoundly true and needs to be remembered at all times.)
   
   
2. Markets change.
   
   
3. While impressive, the past returns we quote for our Workshop strategies come from a limited set of data.
   
   
4. The returns alone don't paint an accurate picture of the volatility that many of these strategies entail.
   

Those who invested in many of the hottest Workshop strategies in January know what I am talking about. Many of you are now suffering through losses that you may not have been prepared for. But such volatility is nothing new. Last week, I talked about using strategies with different start dates and different holding times as a method of risk reduction. Today, I'll talk about an even more important topic: investing in different types of strategies.

When picking the screens you use to select your stocks, you need to be sure you are getting sufficient diversity. The performance of the Relative Strength screens was so impressive for the last two or three years that it was tempting indeed to jump into them head first. Then came this year. While using diverse screens won't prevent losses in down markets, they can make the losses more tolerable and smooth out some of the volatility.

Our Workshop screens fall into three categories (see Screen Explanations for details on the screens discussed):

Value Screens look for stocks that are potential bargains. They look for stocks that are underpriced relative to their potential value. Examples: Beating the S&P (BSP), the Foolish Four. The PEG screens also have a value component.

Growth Screens look for companies that are growing their earnings rapidly and have good potential for future earnings growth. Examples: PEG, Unemotional Growth (UG), Plowback, and Formula 90.

Momentum Screens look for stocks that have the highest recent price appreciation. All Relative Strength (RS) screens and the Keystone screens are strongly based on momentum.

Some Workshop screens concentrate on one factor. The RS screens use only recent price appreciation, although they do it within the context of the top Value Line Timeliness rating, which screens out many "hot" stocks that are running up on rumor only. Others, like the PEG, include elements of value, growth, and momentum. All of the screens mentioned except the Foolish Four and BSP include a Relative Strength element at some point, although UG uses it only as a tiebreaker.

Another useful way to group the screens is by size of company. Screens like Spark, Plowback, and Keystone are restricted to companies with large market capitalizations, while others have no size requirement.

Breaking the screens into their types and size restrictions helps an investor figure out what type of portfolio they are building and ensure sufficient diversification. You want to have elements of all three kinds of screens with some diversification in size.

Once you have a general idea of the kinds of stocks each screen looks for, it's time to select specific screens from each category. We will talk about that some more next week, but in the meantime you might want to review this article, Know Thy Screens, and check out the Reports Archives for 1999 and 2000 for detailed descriptions of each screen.

Investing styles come and go like skirt lengths. You need to have value stocks when the market is in a value mood and growth stocks for when its fancy turns to earnings growth. Some years large-caps stocks are "in," then the market switches its attention to small caps. Unless you can predict these market moods, it's best to have elements of all these investing styles in your portfolio.

Some will do better one year, others the next. Some years they will all do poorly, but with sufficient diversity, you will minimize your volatility and maximize your long-term returns.

Until next time, Fool on!