Establishing a stock portfolio using a stock screen consists of the following steps:
- Selecting an investment strategy which fits one’s temperament, worldview, and preferences for returns vs. volatility.
- Defining the universe of stocks to choose from.
- Deciding on the amount of diversification wanted, i.e., how many stocks to hold.
- Deciding on how the portfolio would be maintained, i.e., rebalance frequency and sell rules.
The first essential step in any portfolio construction is selecting an investment strategy. Such as that there are many ways to climb a mountain, there are many ways to achieve investing success. An investment strategy is a path chosen towards the goal of sustainable long-term investment success. The definition of success may differ for different people and warrants a dedicated discussion which is outside the scope of this article. For now, we will define “investment success” as achieving above-average risk-adjusted returns, as measured by a higher-than-market Sharpe ratio.
Well-known investors have made their fortunes by employing radically different strategies. Warren Buffett has become the wealthiest investor in history by implementing a diversified deep value strategy (owning low-quality ultra-cheap stocks) during the ‘50s through ‘70s, and then by investing in a concentrated and leveraged portfolio of high-quality not-too-expensive stocks. Benjamin Graham and Walter Schloss have practiced Deep Value throughout their entire careers. Ray Dalio and George Soros became billionaires through investing in macro trends. Carl Icahn made his fortune through corporate activism. And so on and so forth. There are many ways to invest successfully, but you can only succeed if you choose a strategy which fully fits your personality, and stick with it.
An investment strategy is not merely a recipe for buying and selling stocks. A strategy is a worldview of how wealth is to be created. One investor may believe that a basket of cheap stocks will earn excessive returns regardless of the issues’ quality. Such investor is likely to be a contrarian in investing as well as in life. The concept of reversion to the mean will make intuitive sense to her as she has seen it working throughout her life. Another investor will insist on investing only in companies that have a firm financial standing and a history of profitability. That investor has had bad experience owning low-quality products hence will be reluctant to disregard quality in his investments.
We believe that carefully selecting an investment strategy is paramount to an investor’s success. The reason can be summarized in one word – resiliency. While every portfolio is initially constructed at a time of optimism and hope, challenging times do arrive sooner or later. At such times, when a portfolio is lagging the market for protracted period; at such times when the investor is widely mocked on for her unpopular holdings or her lack of skill – It is those times in which an investor truly needs an established well-thought-through investment strategy, and a firm worldview – to weather bad times and thrive.
But how does an investor develop a deep understanding and a firm position in an investment strategy? Is it merely upon reliance on past performance, i.e., believing that a strategy stands on solid grounds only because it had worked well in the past? Or are there additional considerations?
We believe that a favorable past performance is necessary but not sufficient. Performing back-tests and statistical analysis for investment strategies is a means to discover and validate what had worked well in the past. Asset prices reflect a consensus between sellers and buyers on the asset’s fair worth. And as such, it is dependant on investors’ sentiments, cognitive biases, and subjective expectations. Thus, the performance of an investment strategy may change over time. Past performance of 20 years back is a good indication of future performance, but it is not bulletproof. Nor is past performance of 100 years back. An additional element is necessary. That crucial element is an investor’s deep understanding and full commitment to the philosophy and worldview behind the strategy he or she had chosen. Only through those, an investor can weather periods, often protracted ones, of underperformance, in the path for over performance in the long-term.
This website is devoted to the study and the implementation of quantitative value-based and momentum-based strategies. Throughout the site, we describe the strategies which we have found to work well and rely on a sound philosophical standing. We delve into both what had worked well and why it most probably had worked well. We also describe strategies that had not work so well and share our views on the reasons why. The commonalities of the strategies highlighted in this website are:
- All advocate investing for the long-term
- All are based on rational and thorough decision-making
- All are based on serious academic research
- All have been tested rigorously using state-of-the-art statistical analysis