Mechanical investing can be a very risky and highly volatile way to invest, and many things can go wrong. Not every strategy works out, and even those that look very promising may crash. But much of the risk can be mitigated to some extent with a properly diversified portfolio, patience, and faith.
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The thing that struck me immediately when I went to Kitty Hawk was that the Wright Brothers had planned to do a lot of crashing. Brilliant mechanics, they knew that failure is part of the process of success.
In the Foolish Workshop, mechanical investing -- which started with the Foolish Four, and which we are exploring every Thursday as a prelude to adding some Workshop strategies to our Foolish Four portfolio -- is well off the ground. In fact last year some strategies resembled Saturn V's. But the process is still being tinkered with. Our community mechanics test and tweak and brainstorm and test some more. Not every strategy works out, and even those that look very promising may crash. Heck, even the ones that are working best crash rather often.
One of the biggest problems with mechanical investing is that results can be very erratic. In today's Workshop column, Todd Beaird tells about two Relative Strength portfolios started just a few days apart. Both used exactly the same selection criteria, but the one started on December 28 (from the December 24 data) is up 53% this year, while the one started on December 31, using new data, is down over 34%.
That's quite a crash. It's also an extreme and unusual case, but that kind of thing can happen with mechanical strategies. Of course, it can happen to the best stock pickers, too. The problem is that too many people look at the backtested history of our strategies and see 30% per year for the last 16 years, and, sometimes even when they know better, an expectation is born.
The real problem, though, isn't that returns can be highly volatile. The real problem is that expectation. Because when a strategy does its normal, volatile thing and crashes face first into the sand, all of a sudden the investor feels betrayed. The strategy is not meeting his expectations. There must be something wrong with it. He sells, locks in his loss, and goes somewhere else. Meanwhile, the strategy recovers.
Here's where things get complicated. Sometimes it doesn't recover. Sometimes there is something wrong with it. A mechanical strategy that has worked well for the past three years, 15 years, or 30 years won't necessarily continue working into the future. Sometimes it will be based on a statistical fluke. (The critics think that the Foolish Four was based on a statistical fluke, and that's why it's not beating the market like it used to.)
Sometimes a strategy that was developed through backtesting may have been valid in past market conditions but stops working because those conditions have changed. (That's my take on the Foolish Four.)
And how the heck are you supposed to tell the difference? Hey, don't ask me.
The solution to this particular problem and the problem of variable returns is diversification. Not stock diversification, but strategy diversification. We will explore that topic in more depth in a couple of weeks, but if you want advance notice on what I plan to say, you can check out the links below for a series written by Todd Beaird and Moe Chernick in the Workshop last summer. Of, if you are patient, you can wait until I steal their ideas.
What else can go wrong with mechanical investing? The market can tank, and the strategy can tank even more. Many of these strategies are "high beta." That means that when the market crashes, they crash harder. (It also means that when the market rises, they soar.) How would you have felt last spring when the Nasdaq was down 40% but your Workshop portfolio was down 60%? That's right. I'm speaking from personal experience.
There's no real cure for that problem except patience. A bit of faith wouldn't hurt either.
All investing is fraught with risk. Without risk, there is no reason for the market to reward investors with average returns that are much higher than fixed investments like bonds or money market accounts. Mechanical investing seems to be discovering ways to beat the market, but the path is not smooth, despite some rather spectacular returns during the last two years.
For our next Workshop Thursday, we will go over some of the criteria used to select stocks for Workshop strategies. You may want to take notes. If I haven't scared you off yet.
Fool on and prosper!
Related Links:
Staggered Strategies, Staggering Returns, Workshop, 7/13/00
Diversification the Workshop Way, Workshop, 6/27/00
Diversify Your Mechanical Strategies, Workshop, 5/23/00
Is Mechanical Investing for You?, Foolish Four, 9/14/00
Balanced Approach to Mechanical Investing, Foolish Four, 9/7/00