What This Strategy Aims To Do
This model invests in stocks we believe will, over time, be more stable than most. The model seeks to benefit from higher potential returns that are typically expected from the equities asset class but is willing to “leave something on the table” during the market’s stronger periods in order to reduce the potential for suffering during weak intervals.
Why It’s Worth Considering
Ask anyone for their opinion about stocks and chances are they will answer with respect to how the market is performing right now and how they feel about it, which is most likely to be influenced by the dollars-and-cents performance of their own portfolios.
Since it’s normal for the market to transition often between strength and weakness, it can be hard to get a bona fide opinion regarding the overall big-picture merits of equities as an asset class. To do that, we need to develop a view that is not tied to whether we are, or have recently been through, a bull or bear market. Financial theory, supported by empirical observation over very prolonged periods, can help us do this.
Without getting academic, suffice it to say that some asset classes have greater potential for return than others. But we also know that higher potential returns are associated with higher potential for disappointment (risk). This isn’t something that just happens. It's inextricably intertwined with the structural characteristics of each asset class.
Looking at the two major asset classes, equities and fixed income, equities are high in terms of potential return and risk, while fixed income is low. (Each asset class can be subdivided and we’ll discuss each in the appropriate context in connection with the appropriate model. We will also address other asset classes -- real estate and commodities -- in the appropriate context.)
Depending on one's station in life many, perhaps most, people find it desirable to have some exposure to equities. Because the values of equities are tied to corporate profits, which in turn are tied to economic progress which is in turn tied to population growth and improvements in productivity, life span, health, education, etc., equities are arguably “hard-wired” for potential growth that is unthinkable for fixed income, where (assuming all goes well in terms of credit quality and interest rate trends) what you see is what you get. Given widespread needs to grow capital (to save for retirement or other large future outlays and/or to improve one’s living standards), it would be hard to suggest that one should completely avoid equities.
But not everybody who stands to benefit from equities (that is, almost everybody) is willing or able to tolerate the potential risks. Even temporary losses hurt when one needs to draw capital now. And besides, temporary setbacks always have the appearance of being permanent until improvement actually arrives. That’s scary. It’s “just” a behavioral thing. But it’s very, very real and deserves to be respected.
If only we didn‘t have to be all-in or all-out with respect to equities! If only we could aim for some sort of intermediate level of potential return (something well above what we can pursue with fixed income) that would expose us to some, but less than the full degree of equity risk.
Good news: That can be done. And that is precisely what this model aims to do.
How We Do It
On paper, it’s easy to do this. Just invest in stocks with low standard deviation (a measure of share return volatility) and/or low beta (a measure of share return volatility relative to the movements of the overall market).
If we could be sure that past results are indicative of what the future holds, such a strategy would be perfect and we would offer one that does just that (as would every other advisor). Unfortunately, the world in which we live is such that not only are we unable to be certain of this, but we can be as sure as human experience allows us to be that there will be many instances in which this turns out to not be so.
So rather than bet the farm on statistical report cards that show what has happened in the past, we build our model upon a foundation constructed with the elements that make a company’s profit stream likely to be more stable than average. We do this by limiting consideration to stocks in a large capitalization universe that rank in the top 35% in terms of a broad-based quality-oriented ranking system we use.
Why, one might wonder do we consider the top 35% rather than the best of the best, say the top 5%? Because that would be overkill. We’re not an awards committee (“And now, the prize for best gross margin over the past 12 months goes to . . . “). We’re investors working to cope as best we can with an uncertain future. All we need is enough strength in terms of quality to allow us to presume that statistical stability comes from something real, something more likely than not to be capable of manifesting in the future. Demanding too much would likely eliminate many truly worthy stocks.
Having established this important “quality” gatekeeper, we can now make use of conventional statistical risk measures. But even there, we go the extra mile. To guard against the possibility of aberrations getting through (an ever-present risk of any quantitative methodology), we use a collection of risk measures computed over a variety of time periods.
After we first screen our universe based on quality, we next require that beta, calculated over various time periods, must be less than 0.90 (1.00 signifies average volatility relative to the market). The remaining stocks are then sorted under a stability-oriented ranking system and we select the 20 best (most stable) stocks for the portfolio.
A note on valuation: Don’t be surprised if you find stocks here with high valuation ratios. It is a common error to assume low valuation equals low risk. In fact, it’s the opposite. See Portfolio123 White Paper # 1 for details.
But even without reading that, it makes sense. Risk protection anywhere in life is a valuable service for which we expect to pay. That’s why we buy fire insurance, auto insurance, “portfolio insurance” (hedging and associated costs), why we avoid junk bonds, etc. So we should expect lower-risk stocks to be priced at a premium.
We refresh the model weekly to check for the potential need to replace positions; we make these decisions based on the ability of stocks to stay above a certain quality and stability thresholds. The model has also been designed such as to limit turnover (although the model is refreshed weekly, it usually finds no need to trade).
Is It Suitable For You?
For those who want and are able to take on exposure to the equities asset class, this is our lowest risk offering. To further reduce risk you would need to focus more or entirely on fixed income. Assuming the model performs as we expect (we try, but neither we nor anybody can ever guarantee), you should feel gratified by your “relative” performance during bad spells for the market. But when the bulls race ahead, be prepared to be in the rear portion of the herd.
Investing In This Model
This model has a high turnover. This is not unusual in rule-based models that depend on data to keep positions aligned with strategy. Due to the turnover, commissions could play a major factor in the returns.
It is also preferable to follow this model in a tax-deferred account to avoid paying short-term capital gains taxes. However, due to the turnover and relatively high number of positions, contributing small amounts each month can be very inefficient depending on your broker.
You can start following the model here.