So you’re tired of getting mixed results with your stock investments, and you wish you had a consistent way of beating the market. Maybe you get too anxious when the market turns against you, making you unsure whether you should sell all or some of your holdings, or take a deep breath and stay invested. This Roadmap will help you develop a system for creating and maintaining a winning stock portfolio that will beat the market over the long-term.
Before we get started, let’s get some motivation. I’d like to invite you to my FREE web class How To Make Higher Returns Than Guru Investors. Yes, I truly think it is possible, and I provide the evidence in the web class.
I also recommend watching my video mini-series Become A Better Investor.
Once you master the essentials, go ahead, and build your winning stocks portfolio by answering the nine questions below.
1. What Is Your Investment Approach?
The first essential step in any portfolio construction is developing an investment approach. 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 on the road to achieving 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, let us 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 investment approaches. 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 wealth 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 that fully fits your personality and stick with it.
An investment approach is not merely a recipe for buying and selling stocks. An approach is a worldview of how wealth can be created. One investor may believe that a basket of cheap stocks will earn excessive returns regardless of the issues’ quality. Such an 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 him as he has seen it working throughout his 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 her investments.
We believe that developing an investment approach 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 a 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.
If you’re new to investing, worry not, you can start with adopting an investment approach that makes sense to you, such as the one laid out on this website. The more you read and learn, you’ll be able to better to articulate and refine your core beliefs.
Here is My Investment Approach.
To learn more about the pillars of successful stock investing, watch (or read the transcripts) of Module 1 of my online course How To Beat The Market With Confidence.
I developed my approach by studying the works of both Benjamin Graham and his disciple, Walter Schloss. I’ve summarized my learnings in the post: The Quantitative Approach.
Many Value Investors study the writings of Warren Buffett, the richest and most successful Value Investor in the world. Buffett’s approach since the 1970s has been different than what Graham and Schloss (and even Buffett himself up until the 1970s) have practiced throughout their careers. I summarize those two approaches in the post: Walter (Schloss) Vs. Warren (Buffett) – An Imaginary Interview.
2. Which Type Of Investor Are You?
We know that you are a Value Investor. But are you a Value investor that cherry-picks stocks after doing some research on them? Or are you a Quantitative Investor using a stock screener to make a computer algorithm make rationale and consistent Buy and Sell decisions on your behalf? We discuss the two types of investors in the blog post titled Which Type Of Investor You Are?
It is no secret that I myself am a Quantitative Investor, although I occasionally (yet rarely) buy Value stocks based on my discretionary research. I describe how and why I became a Quantitative Investor in the blog post: Listen To Graham…Become Quantitative.
3. Which Stocks To Buy?
As Value Investors, Value Stocks (i.e., cheap stocks) are the foundation of our stocks portfolio. There are numerous strategies to finding Value stocks to invest in. Some, such as Deep Value or Net-nets, favor low valuation and disregard the Quality and Momentum aspects altogether. Other strategies, such as Quantitative Value and The Magic Formula, combine attributes of Quality and Valuation. There are also strategies that contain attributes of Momentum, such as Quantitative Momentum and Microcap Trending Value.
To become familiar with the various strategies and their ins and outs, check out our Roadmap to Consistently Finding New & Compelling Investment Ideas.
Don’t feel overwhelmed by the amount of content that is available on each strategy. Read it little by little. Give it time to sink in. Go back to articles and sections you’ve already read, as each time you will discover additional aspects.
A good starting point for your portfolio while you are learning and exploring the various strategies is Quantitative Value.
It is perfectly fine to combine various Value strategies, rather than stick with one. For example, let’s say that you decided to create a Value portfolio consisting of 30 stocks (more on the number of holdings later in this article). Some investors will wish to allocate their entire portfolio to just a single strategy – say, Quantitative Value, or Deep Value. Those investors prefer the simplicity and low maintenance of sticking with their favorite value strategy. Others may wish to diversify between several Value strategies to smooth out their returns and increase their chances of winning in different market conditions. Those investors are willing to take on a little more maintenance work. Examples for diversification:
- 15 stocks of Quantitative Value, and 15 stocks of Deep Value (either EV/EBIT or VC2)
- Ten stocks of Quantitative Value, 10 stocks Deep Value (based on EV/EBIT) and ten stocks of Deep Value (VC2)
- 15 stocks of Graham’s “Defensive Investor” and 15 Stocks Quantitative Value
- 15 stocks of Graham’s “Defensive Investor” and 15 Stocks Magic Formula
There are endless possibilities. All of them are good, as long as you are understand what you are doing. Our Roadmap (linked above) will help you with that.
4. Should You Combine Value & Momentum?
Value Investing is great, and Value stocks should be the foundation of any Value Investor’s portfolio. There is a simple way of improving even the best Value Investing portfolios. That way reduces the portfolio’s volatility, and even enhances total returns. The way is – combine Value and Momentum.
Once you have built a well-diversified Value portfolio, and you have additional money to deploy, you may want to add Momentum stocks, rather than Value stocks.
We give examples of the performance of combined Value and Momentum in the blog post A Momentum Diet – Before and After.
For a comprehensive review of All the options you have for combining Value and Momentum, read our white paper Spotlight on Combining Value and Momentum.
5. How Many Stocks To Hold?
What should be an ample level of diversification? Is it enough to own ten stocks or less, as did Mohnish Pabrai for the most part of his successful career? Or should be better own 60 to 100 issues, as did Walter Schloss?
As a general rule, the more thorough your analysis is on any stock holding, the fewer stocks you need to own in your portfolio. Charlie Munger had said that a well-diversified portfolio might contain as little as four stocks. I respect Charlie Munger very much, and I am a novice compared to him, but I must admit, I don’t subscribe to that notion. From my experience, concentrated portfolios are too volatile. If you hold just ten stocks, and one of those stocks declines 50%, which is not uncommon, your portfolio we lose 5% percent of its total value. And it’s very difficult to hold on to a portfolio that declines steeply and quickly. I think that the reason that many investors do not diversify enough is not that they cannot find good investment ideas, but because they do not have the time to properly analyze them. And quantitative investing can come to the rescue. Using quant investing screeners, you can cut the time you spend on investment analysis because the top stocks that will show on the screener are already attractive from a quantitative perspective. And if you go fully quantitative, you don’t have to spend any time at all. You buy a large bucket of attractive stocks based on an algorithm, and you hold onto them. In my experience, and I’ve done hundreds of backtesting simulations, the minimum amount of stocks you would want to hold in a quantitative portfolio is 20 stocks. The exception would be a portfolio based on Graham’s defensive investor strategy, which selects large and prominent stocks, and then you can reduce the number of holdings to about 15. But for the other strategies, 20 is, I think, the absolute minimum. And 30 is the sweet spot. If you want to more conservative, go even with 40 or 50 stocks.
If you invest through a discount broker, like interactive brokers, you pay a very low minimum commission for every transaction. As low as $1 per operation. Those low fees allow you to diversify broadly even if the dollar amount of your portfolio is relatively small.
To better understand how performance and volatility changes with the number of stock holdings, we performed several backtesting simulations in which we changed only the number of holdings. The following table presents the simulation results of the Quantitative Value (QV) strategy over a period of 20 years, from June 30th, 1999, to June 30th, 2019. Portfolios were rebalanced yearly.
| No. of Stocks | Holding Period | Market Cap Rank | Avg. Annual Returns | Sharpe | Sortino | std. Deviation | Max Drawdown | Correlation | Alpha (%) annualized | Asset Turnover |
| 20 | One year | $200M and up | 17.33% | 1.17 | 1.57 | 13.05% | 43.92% | 0.7 | 13.37% | 26.58% |
| 30 | One year | $200M and up | 18.90% | 1.29 | 1.72 | 12.91% | 44.24% | 0.71 | 14.81% | 28.25% |
| 40 | One year | $200M and up | 17.82% | 1.2 | 1.59 | 13.04% | 46.73% | 0.74 | 13.57% | 27.43% |
The results show that for a Quantitative Value portfolio, 30 stocks is the sweet spot. However, the variations between the results are minor.
We believe that there are two forces affecting the results. On the one hand, the more stocks an investor owns, the less she is exposed to major blow-ups in one or two stocks. The idiosyncratic risks of the individual stock holding are thus reduced. On the other hand, the more stocks the investor owns, the factors affecting over-performance are diluted to a higher degree. Stocks 1 through 10 are the most suitable for the strategy, stocks 11 to 20 are less so, stocks 21 to 30 are even less, and so on. Diversification becomes De-worse-ification.
We received similar results for Deep Value Strategies, and The Magic Formula – 30 stocks are the sweet spot that delivers the best risk-adjusted returns.
An ideal Value + Momentum portfolio will consist of 30 Value stocks and 20 Momentum stocks. The Value portion will be based on either Quantitative Value, Deep Value, Graham’s Defensive Investor, The Magic Formula, Microcap Trending Value, or a combination of those. The Momentum portion will be based on either Quantitative Momentum or Microcap Trending Value.
6. When and How To Buy Stocks?
We list the best stocks to buy, for each quantitative strategy in the following page:
Stock Lists for Quant Portfolios
We recommend keeping a record of the strategy that was used for your stock selection, especially if you diversify between several strategies in a single stock portfolio. That records will be handy when the time comes to rebalance the portfolio.
A common question is whether you should deploy your capital to the portfolio all-at-once, or buy in several monthly increments. We have written a comprehensive white paper on this subject: Spotlight on Dollar-Cost Averaging.
7. When and How To Sell Stocks?
That is maybe the most difficult question to answer when it comes to constructing a portfolio. Different selling patterns had worked well for different investors, yet a consistent pattern did not emerge.
Quantitative Portfolios need to rebalance their holdings every pre-determined period. When the Rebalance date arrives, we need to determine which stocks remain on the portfolio, and which should be replaced. We have experimented with several rebalance periods. The best returns are achieved portfolios are rebalanced yearly (every year and a day – to avoid short-term capital gains tax). The exception is the Quantitative Momentum (QM) strategy, which should be rebalanced every six months.
We have clear instructions on how to do so on our page:
Stock Lists for Quant Portfolios
8. How To Monitor Your Portfolio?
You don’t need to. Ideally, you only need to attend your portfolio on the rebalance date. Your stocks are guaranteed to fluctuate, even materially between rebalance dates (which are typically one year apart). But there’s nothing you really should do about it. Let the Stock Factor play out over the long term. Use the time to read and learn about investing.
9. What To Do When The Market Goes Against You?
First, don’t panic.
I’ve written about market crashes in the blog post How To Survive A Market Downturn
There is a way to protect against major drawdowns. It’s not perfect, but some investors find it useful. I’ve written all about it in the white paper Spotlight on Market Timing.