Wednesday, January 14, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Jan. 14, 1998) -- With our focus here in the Workshop on individual screening models as a way of building a portfolio, it helps occasionally to step back from the individual screens and stocks themselves to examine the philosophy underpinning such an approach.

The use of such screens as the Dow Approach or the Keystone Approach, or any other mechanical screen is based on an idea that I call Strategic Indexing -- a term I've co-opted from Jim O'Shaughnessy.

Because investing can be such a daunting and emotional prospect for most individual investors, using a strategic indexing approach eliminates the biggest obstacles for most investors: fear and doubt. The beauty of an index (as we see with the popularity and success of S&P 500 Index funds) is that the investor doesn't have to re-evaluate investments constantly. It's a way of following a proven strategy with a minimum of additional research. And while we're very much in favor of individual investors doing their own research, we're well aware of the limits on most investors' time.

So starting with a screen that has consistently worked well eliminates a couple of layers of legwork. You immediately screen out all but a handful of stocks on criteria that have worked well historically. From there, you can stop and buy the whole group, or if you've the time and opportunity, take the screen and then work through the individual stocks to choose the best stocks from among them.

I received a very heartening letter today from a Workshop reader who used the screens we followed last year to start his own research. Instead of following the screens mechanically, he used them to start his continuing research process. And his returns for the year -- over 50% -- show the fruit of his additional labor.

The other advantage of strategic indexing is that it acts as a risk reducer. Every time you adjust your portfolio to eliminate some stocks in favor of new ones, you rebalance the weight of the holdings so that you're not simply gambling on one or two very heavily weighted stocks.

And when the strategy inevitably hits a rough patch, the discipline of an automatic adjustment keeps you from making decisions based on emotions. When a good strategy has a poor performance, the worst thing you can do is to bail on it. Inevitably when you do, the next year will be a nice bounce that you'll miss. On the other side of the margin call, when a strategy has a massive year, be careful not to expect that kind of performance every year. We need look no farther than Unemotional Growth for evidence of these kinds of cycles. Yet, the long-term returns since 1987 are quite impressive, despite the potholes the model drove through along the way.

So, look to choose the strategies that match your goals, risk tolerance level, and personality and then stick them out. If you hate being tense and acting quickly, something like Unemotional Growth will drive you to distraction. For others, the monthly adjustments may make you feel you're managing your portfolio more actively. Balance those psychological needs with the more objective goals of minimizing trading costs and taxes while still generating the best possible after-tax returns.

Everyone's solution to this matrix of variables will be different. My penchant for large-caps may be dead wrong for someone who wants to search out the next small-cap technology superstars. Likewise, the ups and downs of small-caps may not be for the investor who wants the relative stability of blue chips.

Regardless of what kind of investor you are, though, using strategic indexing to eliminate emotion is a Foolish move. There are lots of ways to play a fine round of golf. It's the golfer who tries to rebuild his swing on every hole who will never play a fine round. Play your own game if you know it works and let's have one terrific party in the 19th Hole. Fool on!

[Want to be the first Fool on your block to get a copy of Robert Sheard's forthcoming book? Click here to pre-order your copy of The Unemotional Investor.]