Is mechanical investing right for the average investor? That's the question I ended part 2 of my series with, and like most questions, the answer depends on whom you ask.
on mechanical investing
Money magazine columnist Jason Zweig answers with a resounding "no." In his commentary on Chapter 1 of Benjamin Graham's classic The Intelligent Investor (link opens a PDF file), Zweig blasts both James O'Shaughnessy's stock screens and the Foolish Four, primarily because they were formulaic screens and underperformed their benchmarks between 1996 and 2000. But this is inherently a flawed way to view an investment philosophy, since we're most interested in results over at least a 10-year period -- the generally accepted length of a business cycle.
Regarding short-term underperformance, James O'Shaughnessy easily refutes Zweig's criticism:
[Zweig's] judgments were made based on three and a half years of data. The speculative fever on Wall Street was in full swing, and the small-cap and value stocks that the funds were largely invested in were having a hard time keeping up with the technology and growth stocks dominating the big-cap S&P 500. . Had [critics of mechanical investing] spent any time reading the first editions of this book, they would have seen that historically, between 1951 and 1996, the strategy they were attacking had a 30 percent chance of underperforming the All Stocks benchmark in any given year, and a 10 percent chance of doing so over any five-year period. Of course, since then, the strategy has come roaring back and is again handily beating its benchmarks.
Regarding formulaic screens, Zweig is also opposed by Benjamin Graham himself! Graham, whom Zweig calls "the greatest practical investment thinker of all time," argued in his book Security Analysis that a screen of 10 criteria could be used to pick stocks with a "margin of safety." (Graham also advocated looking behind the numbers to guard against accounting shenanigans, but "margin of safety" screening remains one of his core stock-picking legacies.) The criteria (link opens a PDF file) changed over various editions of his book, but the following are representative:
- Earnings to price ratio at least double the AAA corporate bond yield.
- P/E ratio less than 40% of the average P/E ratio for all stocks over the past five years.
- Dividend yield greater than two-thirds of the AAA corporate bond yield.
- Price less than two-thirds of tangible book value.
- Price less than two-thirds of net current asset value (NCAV), where net current asset value is defined as liquid current assets including cash minus current liabilities.
- Debt-equity ratio (book value) less than 1.
- Current assets greater than 2 times current liabilities.
- Debt less than 2 times net current assets.
- Historical growth in EPS over the past 10 years greater than 7%.
- No more than two years of declining earnings over the previous 10 years.
The best conclusion I can reach from this back-and-forth is that the real dispute here isn't about mechanical investing -- it's about the proper criteria for picking winning stocks. Zweig thinks it's deep value, while O'Shaughnessy believes in a combination of value and price strength. The real question for investors is this: What investment criteria do you believe in?
The risks of human investors
Some people might understandably want a living, breathing human picking stocks for them, not a computer. You can't evaluate the experience and integrity of a company's management with a quantitative computer screen (although quants would argue that such factors are reflected in a company's financial performance.)
Still, remember that when you invest with a human being, you aren't escaping the question of investment criteria. For example, Inside Value's Philip Durell screens for value, Tom Gardner uses small-cap, value, and growth criteria, and David Gardner picks stocks according to growth criteria. But even with Foolish investors like these, you don't know what exact criteria they use, or how consistently those criteria are applied. In many ways, investing with human managers is as much a leap of faith as mechanical investing.
A 2005 study concluded that some mutual fund managers who had outperformed their benchmarks for at least five years were truly talented, especially those pursuing growth stocks. But others were just lucky. Unfortunately, the study continued, it was impossible to know which were which. Furthermore, the study couldn't calculate the extent or duration of continued outperformance that investors should expect from truly talented portfolio managers in the future. Adding insult to injury, Morningstar has argued that you can't reliably gauge a fund manager's skill level without at least 20 years of data -- by which time most managers are ready to retire. Depressed yet?
For many years, common wisdom held that a computer would never beat a human champion in a game of chess. But in May 1997, Deep Blue defeated grand master Garry Kasparov. True, Kasparov claims that IBM engineers cheated by overriding the decision of the computer in a few instances, but computers are nonetheless catching up to the human brain. And when it comes to emotional traps of fear and greed, the computer always has the edge. (You could entrust your money to a genius psychopath to avoid these emotional traps, but they don't generally make ideal money managers.) Index funds, a type of mechanical investing, have outperformed 75% of actively managed mutual funds over the long term.
Whatever investment strategy you pursue, remember the concept of "ever-changing cycles." Just when a strategy appears to be a "sure thing," everybody jumps on board, and it stops working. Then, after a period of underperformance, the public becomes disenchanted with the strategy and abandons it, just in time for the strategy to begin working again. The key to investing is to find a strategy based on logical criteria (e.g., low valuation, price momentum) and a long-term back-tested record of success, and then stick with it through the good times and the inevitable bad ones. Staying consistent is not easy -- that's why it's so profitable.
My own experience
I'm clearly a fan of mechanical investing, but I realize that monthly screens are not as dreamy as advertised when one factors in trading costs. That's one reason why I like O'Shaughnessy's "cornerstone growth" yearly screen, which minimizes those costs. As of Jan. 27, the top five stocks from this screen were Frontier Oil
I have invested on marketocracy.com's portfolio-simulation website for almost three years now, slavishly using O'Shaughnessy's cornerstone growth strategy as my guide. Over the two-year period ending Dec. 31, my play-money fund has more than doubled the return of the S&P 500 and outperformed 96.6% of the funds on the site. Convinced?
I could merely be lucky, since my fund covers only a two-year horizon, but that misses the point. It's not the track record of the investor that matters, but the track record of the investing strategy used. Make sure you only use time-tested strategies -- mechanical or otherwise -- that have superior backtested performance over an entire business cycle. That's how you, too, may become as "lucky" as I've been.
Flash back to further Foolishness:
- The Allure and Illusion of Mechanical Investing: Part 1
- The Allure and Illusion of Mechanical Investing: Part 2