Quantitative Common Sense

 | Apr 12, 2013 | 2:00 PM EDT  | Comments
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I am fascinated by the fully mechanical approach to investing but there is a major flaw that keeps me from implementing it in my own portfolios. Advocates of fully mechanical, systematic approaches to investing and trading quite correctly note that it removes emotion and bias from the process. That can be a good thing. However, I find it difficult to pull the trigger even on a really cheap stock such as Hartford Financial Services (HIG) when the market has been strong and the stock is flirting with 52-week highs.

This approach can help investors take profits in a rational manner and it doesn't suffer from my inherent dislike of certain sectors and companies. Yet it also removes something I think is critical to the value investing process: the common sense that I honed from working in the markets for two and a half decades.

It makes more sense to buy in a down market than it does to chase new highs. I have found that buying on a scale on the way down and selling on a scale on the way up -- based solely on fundamental factors -- removes a lot of stress and guess work from the investing process. The old adage that it doesn't matter when you buy is simply Wall Street sales material and it can harm attempts to build wealth via the equity markets.

It makes sense to buy stocks like you buy groceries: Take advantage of periodical sales by loading up your basket.

Let's take a look at some examples of purely mechanical approaches vs. a little of my "common sense, buy them when they are down" approach. We'll assume that I have developed an approach that has been shown to outperform the broader stocks market by 50% over time.

I go to put my money to work after my exciting discovery in April of 2000 when the market is peaking as the end of internet mania approaches. Between then and today, the market (as measured by the S&P 500) earns a total return of 2.58% annually. My significant edge over the broader stock market gives me an annual return of 3.87%. That's fantastic if I am a Wall Street mutual fund manager evaluated on relative performance, but not so great if I am an absolute return investor trying to build wealth.

Here's another example. I have found a huge edge in bank stocks over the years using a few simple metrics. If I start my program in April of 2006 -- after an extended rise in the market -- the bank stock index loses about 6.5% annually. Even if I can cut that loss in half with superior stock selection, I will lose 3.25% a year. If I wait until the disaster  hits and start out in April of 2009 (when the market was at a point of maximum pessimism), my return becomes significantly greater. The bank stock index picks up almost 17%. If I have a 50% edge as a result of my stock selection, I compound my money at more than 25% a year for four years.

I am a huge fan of quantitative value investing based on the extraordinary body of evidence that it works very well over time. Picking portfolios of stocks based on value metrics handily outperforms the market and can give you a significant edge over other investors. Still, blindness to general market and economic conditions can seriously devalue your edge. Lower losses or outperforming very low returns may make it in the relative value world of Wall Street but it doesn't pay the bills down here on Main Street.

I am not saying that you should try to predict the movement of the markets. I have said time and time again that I believe that to be a futile exercise at best. However, you can react to what the market actually does and begin or ramp up buying bargain issues after the market has declined significantly -- and then exercising caution following an extended run. Markets, like everything else in life except literature and wine, do indeed revert to the mean. It is just common sense.

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