A good Workshop investor can diversify among stock strategies in several ways. In addition to selecting different types of screens (growth and value), and using strategies with varying holding periods, you can also stagger the start times of your strategies.
By Todd Beaird
First, let's review some characteristics of a good mechanical portfolio. In general, you want to select a blend of strategies to reduce overall volatility while preserving high returns. In math-speak, you want a high CAGR (high average annual return) and a low GSD (low volatility). Remember that no combination of strategies will ever completely eliminate volatility. It's important to know your risk tolerance and be patient as an investor.
Another essential part of a good Workshop portfolio is maintaining low friction costs. Some basic rules of thumb are to keep commission costs under 2% per year or under 10% of CAGR. For more on these rules, review these articles by Moe Chernick and David Trammel (LAPropDoc on the boards). (You have stopped by the Foolish Workshop discussion board, haven't you?)
A third useful tool is to choose strategies with different holding periods. Some of our screens choose stocks that tend to perform better with longer holding periods. On the other hand, some screens (such as the Relative Strength screens) have had excellent returns when traded quarterly or monthly. If you want a good blend of strategies, you will probably use varied holding periods. Also, if you have some funds in a taxable account, you might prefer annual strategies to take advantage of lower tax rates on long-term capital gains.
Every mechanical portfolio involves a balancing act with these three factors. The more strategies you use, the more stocks you will own, which means higher commission costs. In addition, strategies with short holding periods will have much higher trading costs and higher taxes, if they are in a taxable account. But, many of these frequently traded strategies have shown outstanding returns.
Another issue to think about is the validity of the Mechanical Investing approach. We have a lot of faith in our screens, but it is always possible that some of our superb historical results are attributable to little more than random chance. The more strategies you use in your portfolio, the greater your chance of picking a "clunker" that is likely to do little more than match the S&P 500. Yet, the more strategies you use, the less you will suffer if that clunker does fall apart.
As mechanical investors, we try to balance all these factors as best we can, tailoring our portfolios to our personal situations. Moe Chernick's Real Money Portfolio is an excellent example of that balance. Moe's portfolio does not use staggered start dates, although he has stated that such diversification can be important.
So, how can staggering your start dates improve your mechanical portfolio? Here are a few examples.
By staggering start dates, you can trade more frequently, without incurring dramatic commission costs.
Let's say that you would like to trade at least part of your portfolio monthly. However, you want to keep your commission costs at a reasonable level, or you may not be enamored with monthly strategies.
Rather than using monthly screens, you could use a combination of quarterly strategies (perhaps an RS-Overlap quarterly); some semiannual screens (maybe a simple PEG26 dual-semi approach, which uses two semiannual PEG strategies started three months apart); and two annual strategies (such as a growth strategy like Spark, and a value strategy like Beating the S&P).
Now, let's say you start your first PEG screen in January and your second screen in April, rebalancing each one every six months. Then you start your quarterly RS strategy in February and your BSP strategy in March (shortly after the newest lists come out for selecting BSP stocks), and your Spark portfolio in... oh, let's say September. Your trading schedule would look like this:
Month Screen rebalanced
January PEG(1)
February RS-O
March BSP
April PEG(2)
May RS-O
June None
July PEG(1)
August RS-O
September Spark
October PEG(2)
November RS-O
December None
As you can see, you'll be trading part of your portfolio almost every month and use five different strategies (well, counting the PEG semi twice), but without the large transaction costs of several monthly strategies. True, you won't be trading all your stocks every month, but you will feel as if you're trading more frequently than you really are. Which leads to the next point.
Staggered start dates can help maintain your discipline in following mechanical strategies.
We've said it before and we'll say it again: Discipline is one of the most important traits of a successful investor. Our mechanical strategies help enforce that discipline by providing clear guidelines on when to make any changes. This sounds easy, but just wait 'til you encounter a rough time in the market. Although the best advice for surviving a crash is often to sit on your hands and do nothing, that is very difficult for most of us to do. By staggering your start dates, you can feel like you're "doing something," but at the same time you'll simply be following your predetermined strategy.
Staggered start dates can help improve risk management and reduce volatility.
As Elan Caspi (TMFElan) demonstrated at the Mechanical Investing Convention, our screens can exhibit considerable variation in returns from week to week. The PEG screen, in particular, can show wildly varying returns depending on the week it is begun.
If you start all your screens at the same time, you run the risk of choosing the occasional bad week. Staggered start dates help to smooth out these inevitable fluctuations. One strategy might start at a "good" time, and another might start at a "bad" time, but this is likely to balance out in your overall portfolio.
Staggered start dates can make it easier to allocate new funds.
Because you will be rebalancing part of your portfolio more frequently, you can choose to add cash to each portfolio as it comes due. This means that additional contributions can spend less time in a money market fund or index-tracking instrument such as a Spider (AMEX: SPY).
Staggered start dates aren't a panacea. Our strategies will always have some measure of risk. One problem with using staggered start dates is that it makes it difficult to rebalance cash among various strategies. Because of that, some people choose to let their strategies run almost as if they were separate portfolios to avoid having to shift cash from one strategy to another.
However, Alan Levine (alevine) has done some impressive work on the Mechanical Investing discussion board indicating that a balanced blend of strategies can lead to higher CAGRs than simply running the strategies separately. Periodically shifting cash from the higher-performing strategies into those that have not recently performed so well actually improves long-term returns, as long as the mix of strategies is complementary. In other words, the "whole" (blended portfolio) is greater than the sum of its parts (each individual screen).
Until next time, Fool On!
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