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Here in the Workshop we have some strategies that have shown very high backtested Compound Annual Growth Rates (CAGR) -- some in the neighborhood of 65% to 70% over the last 14 years. But how can you actually achieve those returns, or get close, if you have to pay commissions and spreads (which are not factored into the backtest)?
There is just no way around it. It's going to cost you money to make money. The biggest costs for investors are commissions, spread, and taxes, what we on the Foolish Workshop board call "friction." Moe Chernick, in his series on the Costs of Screens, showed why we need to take costs into consideration in choosing our screens.
Taxes have been covered in other Workshop articles. Today we focus on the other two costs -- commissions and spread. It does no good to invest in a high-return, monthly strategy if costs take most of your profit. And that will happen if your initial investment is too low, even if the strategy performs as expected.
The Motley Fool recommends keeping commissions and spread below 2% of your portfolio value. This figure is used for Rule Breaker and Rule Maker strategies, as well as the Foolish Four and its variants. Two percent sounds good. I would certainly not want to go higher.
If you keep costs below 10% of your estimated annual return, that will keep your costs under 2% of your total portfolio value even if your average return is not quite up to your expectations, and that will let you realize 90% of the expected CAGR when it is.
So now the question is: How big a portfolio do you need to keep costs below 10% of CAGR?
The Mechanical Investing community has hashed out this question and -- in an amazing (but perfectly typical) cooperative effort -- come up with the Universal Friction Calculator.
The calculator is based on Mark Meyer's math, which can be rather intimidating, especially if you are like me and have trouble balancing your checkbook. But Jeffrey Clarke's calculator is an Excel spreadsheet that lets you plug in your own starting cash, commissions, spread, and, in a later version, taxes. Download a copy and play. If you have any questions or suggestions for improvements, drop in to the Foolish Workshop and let Jeff know.
Here are some sample numbers generated by the calculator:
Initial investment needed per stock to return 90% of CAGR*
CAGR Monthly Quarterly Semiannual Annual
10% --- --- $9,280 $2,890
20% --- $10,800 $3,120 $1,290
30% --- $5,300 $1,940 $ 860
40% $187,246 $3,630 $1,440 $ 660
50% $51,640 $2,800 $1,160 $ 540
60% $23,770 $2,310 $980 $ 460
*Based on $10 commissions and 0.25% spread.
How to use the table:
Suppose you wanted to invest in a screen that has a historical annual return of 40% (for example, the Spark4). The amount needed to fund an annual screen with a 40% return would be $660 per stock, or $2,640 total, an easily achievable level of investment for most people.
Another example, the popular RS26 strategy, when held quarterly, has returned 55% for 1986 through 1999. You would need about $2500 a stock, or $10,000, to properly fund this screen.
So what does this tell us?
First, notice the large amount of money you need to fund monthly strategies if you expect to receive 90% of the pre-cost CAGR. It should be pretty clear why we don't recommend monthly strategies for small portfolios, no matter what the return. The frequent commissions and the eroding effect of the spread on every trade make it very difficult to actually achieve the kind of returns you may be expecting.
Can you invest less? Of course. It's your portfolio. Some people see the great returns some of our screens have had in the last couple of years and figure that 10% or even 20% in costs is acceptable. But what happens if that hot screen has a bad year? You still pay commissions and spread on every trade. With a five-stock monthly screen, you could be making as many as five trades a month.
Returns come and go, but costs will always take their bite first.
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