Workshop Portfolio About to Begin
The new Workshop Portfolio will be somewhat experimental and quite volatile. It is not suitable for investors who aren't prepared for 40% drops in their holdings. We will attempt to mitigate that volatility by using strategies that tend to pick different types of stocks. One way to test a blend of strategies is to look at its risk-versus-reward ratio. A good blend will have a higher Sharpe Ratio than the component strategies. We are also considering including more strategies than originally planned but picking fewer stocks from each strategy.
By Ann Coleman (TMF AnnC)
November 27, 2000
We are entering the homestretch for picking the strategies that will go into the Workshop Portfolio, which will start on January 2, so I want to try and summarize what we have discussed so far. On Wednesday we will present a tentative mix of strategies and play "Can you beat this?"
The first point, and one that we need to always keep in mind, is that Workshop strategies are experimental in nature and backtesting has shown that they can be highly volatile. Heck, this year has shown that they can be highly volatile. But that hasn't come as a surprise to those who have looked at the backtests carefully. Investors who can't stomach a quick 40% drop in their portfolios should be looking elsewhere for ideas. Hopefully, there will be considerable volatility on the upside too, but I don't know anyone who finds that a problem.
Building a portfolio from strategies that are philosophically different is one way to mitigate volatility without sacrificing potential returns. So for our new Workshop Portfolio, we want to select strategies that pick different types of stocks. For example the Keystone 100 selects large-cap stocks while the pure Relative Strength strategies, which have no such restriction and which look for high price momentum, tend to pick smaller companies. PEG stocks tend to be smaller as well and to have high price momentum, but PEG stocks are also selected for high estimated earning growth and a reasonable P/E ratio (reasonable relative to their growth).
What we are looking for is synergy -- a portfolio where the individual strategies complement each other. When one has a bad year, another, that has picked a different type of stock, can help take up the slack. Bear in mind that this process is a "best guess" kind of thing. Even though we can test blends in the wonderful Jamie Gritton Backtest Engine, the data is limited to the past 14 years, and its applicability to the future is questionable. But it's a reasonable way to decide just which blend to choose given that we can't remove all elements of uncertainty from the choice.
One test of the synergy of a portfolio blend is the Sharpe Ratio -- a measure of the amount of risk per unit of return. So one characteristic we are looking for is a higher (better) Sharpe Ratio than the S&P 500 Index. That would give us a strategy that theoretically has a better risk-adjusted return than an index fund. I emphasize "theoretically" because our backtests go back only 14 years for many strategies, which is hardly enough to cover all market types.
The Relative Strength strategies, which have been tested back to 1969, do hold up well in the earlier time periods. But in most cases we have only the period from 1986 to the present, so our Sharpe Ratios cannot be assumed to project into the future.
Another way to test the synergy of a blend is to look at the correlation coefficients of any two strategies. Todd Beaird will be running some of those when we get down to picking the final mix.
A number of Fools have sent in blends that have great returns and low volatility, but most folks seem to have tested them only on January data. A more valid test is the average return for portfolios started in all months, what the backtester calls an All-Months Summary. (Note: Develop your blend using the Blender Backtester, then move the URL code for that blend into the All-Months Summary to get all strategies tested over all months.)
One thing we have learned from our Foolish Four experience is that January returns can be misleading. So we are going to look for a blend that performs relatively well no matter which month it starts in, even though we will be starting in January.
Another way to diversify the portfolio is to select strategies with different holding periods. That's easy since some strategies have fairly strong evidence that favors one holding period over another. Check the returns shown on our Screen Explanations page to see what I mean. Relative Strength and PEG strategies perform best as monthly or quarterly strategies while Keystone and Plowback do just as well with longer holding periods. (If there is no clear advantage to trading more frequently, it makes sense to save the commissions and trade annually.) I'll confess, after this year, I like the idea of a strategy that is updated monthly. It would come as a relief to watch different stocks go down for a change.
Finally, we want to be sure our portfolio holds enough stocks to provide adequate diversity. One way to do that is to go "deeper" into each screen. There's no magic rule that says that you have to pick the top five stocks from a screen. We often use that number for convenience, but one could certainly buy more. But a better idea could be to buy fewer stocks from each screen and add a few more strategies.
One of the hallmarks of a valid strategy is that the average returns drop off for the stocks that are farther down the list. In other words, stocks that have less of the characteristics that the screen is looking for don't do as well as the stocks that are stronger in those characteristics. Makes sense -- if your screening criteria really are valid. So while I was originally thinking about four screens with five stocks each, now I'm thinking more about picking the top three stocks from six strategies.
But this portfolio is up to you. What do you think about including more strategies? Let us know on the Foolish Workshop discussion board. Elan Caspi will be posting a possible mix that looks fairly good. Can you beat it?
Fool on and prosper!
