A rule based system for investing:
See the list of stocks in “Model List of Growth Stock Ideas”.
Invest in that list with equal dollar amounts in each stock. Next month re-balance
your portfolio and invest equal dollar amount in the new list shown on that
tab. Even though the list on that tab is updated every week, the system
proposed here is re-balancing every month.
The system is bases on two parts.
The first part mentioned above is based on the study of biggest
past stock market winners. The philosophy here is that stocks generally sell
for what they are worth. It prefers to focus on companies that are still in a
stage of earnings acceleration. The list
of stocks in “Model List of Growth Stock Ideas” is based on this principal.
The system identifies companies with strong fundamentals—
enjoying big earnings increases — and buying them when they emerge from price
consolidation periods or when prices have started to respond to good
fundamentals and show a strong upward price movement. This is before they have
dramatically advanced in price.
The momentum factor for earnings combined with the momentum
factor for prices have produced very good results as shown by the Index
performance.
The drawback with this methodology is large drawdowns and high
volatility. Upside volatility is a positive factor which produces exceptional
upside returns.
To minimize the problems of drawdown and high downside
volatility the system incorporates “Tactical
Allocation”. This
is the second part of this system.
In “Tactical Allocation” asset’s trend (Index trend) is compared
to its own performance. If the absolute momentum of the Index is slowing down
compared to 12 months ago switch to a mix of Short and Intermediate term bonds.
When the Index momentum turns up again, switch back into the selected stocks.
Here’s what is good about the strategy:
1. It’s
rules-based. There’s no discretionary decisions required. The relative
momentum rule for earnings and price picks “good” growth stocks. The “Tactical
allocation” rule triggers switch between stocks and bonds based on which is
performing.
2. It’s a
low activity strategy. The rules are only checked once a month for
rebalancing purposes, which leads to a fairly low turnover compared to other
momentum strategies. The rules for “Tactical allocation” are checked
weekly.
3. It’s
based on both historical evidence and investor behavior. The
back-test makes sense as do the behavioral reasons for the momentum
factors. All good investment strategies are based on taking advantage of
other investor's behavior.
Now for some drawbacks and caveats:
1.
The psychology of going all-in or all-out. It is a simple
strategy, but having any position in the markets is never easy. It can be very difficult
to psychologically go from an all stock to an all bond position. Some investors
simple cannot stomach following “Tactical Allocation” signals, no matter how
simple they may be.
2.
Back-tests
only tell you what has happened, not what will happen. This is true of all
investment strategies, but it’s worth remembering that the future is promised
to no one in the markets.
The verdict?
You have to know yourself as an investor when considering this
type of strategy. It’s more about knowing yourself than understanding the
strategy.
Even simple strategies are never easy to implement. This system
has worked in the past, but investors have to define what “works” means to
them. We say an investment strategy “works” if you’re to follow it over many
different cycles. It never “works” if you bail out at the first sign of trouble
or relative underperformance.
Summary:
The System is an approach to achieving risk-managed exposure to
the anomaly across asset classes. It establishes
meaningful controls over investment risk, once an asset's value begins to
decline. It removes emotional and behavioral biases from the decision-making,
while taking advantage of these same biases in others to achieve
exceptional returns.
