I was recently asked a series of questions during a webinar that I promised to answer on a blog. Here goes!
Question 1 “The future is not the same as the past, if everything you do is based on the past, how can it work in the future?
Let me start with two points of reference: (1) George Santayana said “those who ignore the past are condemned to repeat it”! (2) In another blog we included quotes from stock market guru Benjamin Graham; they confirm our view that experts who spend their lives trying to anticipate short term trends in the market….fail.
Because the future is unpredictable in detail we believe that trying to forecast what will happen to stock prices in the short term is an exercise in futility. However, most investors (as opposed to speculators) are vitally concerned with what happens over a period of time, and that’s a very different story! We set out to study stock portfolio performance over many years, but in order to make the study work, we needed to establish that the rules of investing would be exactly the same, year after year, so that we had a level playing field. What we find is that performance varies from year to year because the environment varies, but some investment strategies sustain excellent performance over periods of time, and the longer the period, the more consistent they become. Examples show if you had used the same investment strategy over an 8 year period starting at any time since 1987, the return would be far higher than that of the SP500 index, while the variation (or “risk”) that depends on which year you started, would be comparable to that of the SP500 index!
Bloodhound shows you returns for every year since 1987 and compares them with the index, but remember that the analysis you are seeing includes Black Monday (in 1987 the largest one day fall in the Dow in history), and two wars, and 9/11, and two occasions in which the SP500 index fell by more than 50%. If you can see that your invstment strategy sustained high performance through those investment situations, doesn’t it give you more confidence going forward that trying to pick wisdom from paid forecasters who suffer no penalty if they are wrong?
Question 2. “What do you do when the market crashes?”
This is not easy to answer. There are several approaches you can take to try to mitigate the impact of a market fall (1) buy a larger portfolio so that their rises and falls even each other out (2) buy more conservative stocks because variations in the price of large company stocks are smaller (its hard to move a battleship, and they are followed by analysts minutely); by large company in this context we mean high revenue or profit, not market capitalization because speculative stocks are often bid up in price to high capitalization while their operations are relatively small. (3) buy stocks with low beta (measures their price volatiliy compared to the indexes, which means they behave more like the index) (4) buy an index fund, or (5) hedge your investment with circuit breakers or the addition of hedge funds that move against the market. All of these can reduce the extent to which your investment fluctuates, but at the same time, each technique lowers the return you will obtain.
Our experience in the 10 years in which we have worked with Bloodhound is that performance over periods of time evens out. Volatility can be bad for you nerves and for short term performance, but when the market recovers it is your friend because you recover faster than the market. If you examine the Bloodhound Model Strategies you can select investment strategies that range from Conservative to SuperAggressive; with one exception they are all one-year buy and hold strategies; so you buy, and except for mergers etc, you stay with the stocks for a year at a time. That means that you do not follow the ups and downs, whether a market flutter is attributed to whether Greece is going to implode because the EEC is unwilling to do nothing about it, or whether a political party will do badly in the mid-term elections. Experience shows that these things happen every year, and all the time, but the reasons vary and investment success comes from ignoring the noise and staying with the strategy you picked.
Question 3 “I use stock testing software from A/B/C; how is Bloodhound different?”
Our goal in designing Bloodhound was to empower the equity investor. That meant trying to create a complete environment in which the investor could learn, test ideas before investing, and have access to tools that were familiar, but enhanced. For example we include a stock screener, but we designed it to overcome the major disadvantage that most stock screeners have, that they only screen stocks as of yesterday, so you can only find out whether the screen worked or not by waiting! As we have 23 years of stock history, we designed Bloodhound’s screener so that you can run the screen, and measure its success, between any dates you pick. So, for example, you could test your screen across 2008, of 2009, and see how it performed in very different markets. Simlarly, when we designed a life time planner, we recognized that life’s circumstances are very complex. with career changes, school fees, changes in real eatate etc etc. So in Bloodhound LifePlan we let you input all of these, but them we solve them to tell you what return on your capital you need to maintain in order to maintain the lifestyle you want. So the difference is firstly in the concept, of long term investment using rules that you can try before you buy, and then providing tools that are best-in-class. If hedge fund managers are using the system, we think we succeeded!
Question 4. “Isn’t this basically just stock screening?”
Defining a Bloodhound strategy starts with screening, in which we can include not only fundamental parameters, but also technical algorithmsand custom functions. However, screens pass different numbers of stocks depending on the market, and our goal is to create a portfolio with a fixed size that allows us to achieve the diversification that we want. We call the stocks that pass our screens the “candidates”: these we rank using a ratio that we express as a Measure of Value (MOV) ( Earnings is one example) divided by the Cost of Obtaining that Value (COV) (the price of the stock is an example). By calculating MOV/COV for the candidates we are able to rank the candidates and pick the highest ranked for our portfolio (in the example I used, this would mean selecting them based on the PE). That way we know we are always maintaining a portfolio of fixed size. The ranking is very, very important; when they screen, investors often over specify the screens to reduce the number of qualifying stocks; this, in our view is counterproductive. Bloodhound screens to select the type of stocks we want but then the primary selection is based on ranking; we fine this has a major effect on portfolio performance.
There is a third element in a strategy, the investment rules; these include the amount invested (not everybody can afford Berkshire Hathaway!), and the minimum holding period for the stocks, which is the period after purchase during which you do not evaluate the stock for replacement. Some have called the Bloodhound system “screening on steroids” but it is really much more subtle than that and produces very different results.
Question 5. “If all your users use the same strategy; won’t we end up owning the same stocks?”
No. Portfolios are selected by a combination of fundamental and technical data. While fundamentals change quarterly, they are not synchronized, and technical, especially pricing, varies daily. That means that a given strategy will select different stocks over time depending on the date of investment. Because an investment strategy includes a minimum holding period, that means that investors following the same strategy may hold different portfolios. As we show in our analysis, it is better to stay with the strategy than to continually change the stocks to follow market conditions. Why is that true? Because stocks vary in price all the time, and very often they will fall in value just before taking off, so in our experience trading infrequently not only improves your investment performance, it lowers your agitation!
Question 6. “How much do I have to invest to use Bloodhound?”
There is no hard and fast rule, but we feel that investors should be investing around $25,000. With a portfolio of 10 stocks, that means $2,500 in each stock, so trading costs are relatively smaller, and with a buy and hold strategy, they are miniscule. If you use a SuperAggressive strategy, the return can be high enough that you could reasonably start with a smaller sum, but you have to remember that high return investment strategies also tend to be more volatile and so you have to be concerned about starting n a down year because recovery is harder. Just recently the SP500 index fell 50%; that means that $10,000 fell to $5,000, and to recover your position, you now need a gain of, not 50% but 100%. Recovery is always harder, and then you have the Bloodhound subscription to include….. $25,000 is probably the best minimum investment at this time.
Question 7. “What happens if I want to add to or subtract from my portfolio?”
When Bloodhound creates a portfolio around a strategy that you have decided on, it allocates the money you want to spend equally amongst the stocks of the portfolio, taking out an estimate of the trading cost. Later, if you feel that stocks are getting unbalanced, you can run portfolio rebalancing to see which stocks to trade to bring it back into line. If you want to add money to, or sell from your portfolio, our recommendation is that you do it proportionally. Bloodhound shows you what percentage of your fund is in each stock; calculate the number of stocks to trade by prorating the current allocation with the change that you plan to make. There is not an automatic way to do that at the moment.