# Rules Based "Investing"



## amitdi (May 31, 2012)

Let me re-iterate the title again. It is rules based investing and not trading.

I just finished reading "What Works on Wall Street". It talks about buying a portfolio based on a rule without second guessing it. WWWS's most of the strategies consist of 50 stocks, but it has applied some of those strategies for 10 and 25 stocks too.

I am seriously considering putting 10K towards 10 stocks based on a rule or 12.5K towards 25. One other important point is unlike trading, you are not in or out. With this, you are in the portfolio all the time, its just the selection is completely rules based and changes annually. So it is irrelevant that market is at all time high.

Has anyone been investing in a portfolio based on a preset rule. Considered it? Thoughts/Comments?


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## Asterix (Jul 19, 2012)

25 stocks sounds like a lot to me... let alone 50! What's the "rules" of the strategy as described in the book?


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## amitdi (May 31, 2012)

Asterix said:


> 25 stocks sounds like a lot to me... let alone 50! What's the "rules" of the strategy as described in the book?


One of the first rules he mentioned was Dogs of the Dow. I dont have the book now (had borrowed from the library). All the rules were applied on last 70ish years of data. The most successful were counter-intuitive for e.g I remember one which was filter all small cp stocks with PS < 1. Rank these by their 1 yr price chg and buy the top 10. Although it seems against common sense to buy stocks that have gained the most, the data shows otherwise.

The book has more than 25-30 of these strategies, all mechanical.


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## GoldStone (Mar 6, 2011)

amitdi said:


> Has anyone been investing in a portfolio based on a preset rule. Considered it? Thoughts/Comments?


Sure, lots of people invest this way. Run a preset stock screen once a year, or whatever frequency your strategy calls for. Buy all stocks in the screen in equal weight. Hold for a year. Rinse and repeat. Best done in a tax-sheltered account.

If you want to get full-nerd credentials: 
* call yourself a _quant_
* describe your investment style as _quantitative investing_

The tricky part is getting access to a good quality stock screener. Free stock screeners suffer from poor data quality. Professional stock screeners like Bloomberg are hugely expensive. You have to find a sweet spot: an affordable stock screener that returns reliable data. Search the forum for previous stock screener discussions.


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## GoldStone (Mar 6, 2011)

Forgot to mention:

Take a look at AAII - The American Association of Individual Investors. They offer a variety of pre-built screens to the members (including a bunch of O'Shaughnessy screens). Membership is affordable.

http://www.aaii.com/stock-screens

Another option to explore: StockRover. Not sure how good their data is.

http://www.stockrover.com/


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## GoldStone (Mar 6, 2011)

AAII web site:

James O'Shaughnessy
“What Works”: Key New Findings on Stock Selection

William Bentley from Kentucky posted this comment to the article:



> Early last year, I attempted to put O'Shaun's very good work to practice, adding to it some of the work done by another researcher. I used Stock Investor Pro to generate data, first filtering to meet the authors' market cap filters. I downloaded the data into Excel. Very few of the exact metrics were provided; some of those could calculated in Excel, in many cases data was missing, requiring that I try to collect the raw data from other sources. After sorting, I then computed composite metrics using multiple factors. In summary, you can't screen directly using SIP, and the amount of work required to do on your own is quite substantial. Add to that the inability to effectively back test, and I shelved this concept. Too bad, I think the author is on to something.


I think that describes your typical experience with a non-professional screener. DIY quantitative investing is hard work.


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## Xoron (Jun 22, 2010)

I've read WWoWS as well and like what he's "selling". Practically, it sounds like it should work and the author backs it up with a lot of stats and tables. I've not pulled the trigger on any of his models, but did consider it.

Another "rules based investing" is the Magic Formula Investing (MFI). Designed by Joel Greenblatt the book is "The little book that (still) beats the market", it's based on buying cheap stocks and make good use of their capital. I'd suggest reading it too. Simple, short, and pretty easy to understand the concepts he's proposing. 

This is my starting point for my USD portion of my portfolio. I use the screener on www.magicformulainvesting.com to get a list of MFI stocks, and buy 6 of them every 3 months (selling the previous 6 purchased 1 year prior).


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## lonewolf (Jun 12, 2012)

Hi, Amitidi

I have a rule & that is do my own thing be true to that which my eyes tell me is true & not to se the world through the eyes of others.

Like almost all traders/investors you are breaking the rule of not doing your own thing.

From experience we all have different knowledge & understanding. I have differnt knowledge & understanding in the market then you as you have differnt knowledge & understanding then I do. We both have differnt personalities Emotions are automated value responses issuing from the subconciuos within a context of an individuals knowledge is for him or against. Every emotion has a kenetic element as an imputus to engage in action related to the particular emotion involved. If your understanding & knowledge is saying buy & the other persons method is saying sell. Your emotions will cause you to protect that which you value most highly.
Emotion will over ride trying to follow someone elses method if your personalities & understanding & knowledge is differnt.

Rule 101 in investing is develope your own method that gives you an edge that is based on your knowledge, understanding & fits your personality.

The number of independent thinkers is a lot, lot, lot, lot smaller then most realize i.e Galileo & the rest of masses thinking the world was flat. Ever watch a flock of birds rarely does one bird stays when the rest flies away when something spooks the flock.


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## Canadian (Sep 19, 2013)

I've done some of my own research for this method before. I find this topic very interesting and could possibly generate superior returns. Like what Goldstone said, it's hard to find a screener with quality, up to date information, which is essential for quantitative investing. Recent information, of course, is always available through a variety of sources, but it can be time consuming to extract quarterly or even annual information from a variety of companies' financial statements. I have used variations of quantitative methods before (hybrid methods, if you will) where I do a preliminary screen based on a few metrics, using up to date information. After, I pick the top X number of companies and use a few qualitative metrics to eliminate companies from the mix (i.e., companies that I feel have a competitive disadvantage in their industry, management issues, or if my selection is too concentrated in a particular industry). I like this method for my investment objectives, but of course it is not fool-proof.

One word of caution when doing quantitative investing is to look at your list of results a bit beyond your desired number of holdings. By that I mean if you want to hold 10 stocks, look at your top 15 or 20 results. A current holding may end up 12th on your screener and could likely end up in your top 10 on the next screener - this saves you transaction fees. The TSX isn't a very big index - you will find a lot of repeat stocks on your screener, unless you include microcaps.


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## andrewf (Mar 1, 2010)

If everyone worked rally hard, they could all be above average investors and beat the market. Or something.


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## MrMatt (Dec 21, 2011)

amitdi said:


> Let me re-iterate the title again. It is rules based investing and not trading.
> 
> I just finished reading "What Works on Wall Street". It talks about buying a portfolio based on a rule without second guessing it. WWWS's most of the strategies consist of 50 stocks, but it has applied some of those strategies for 10 and 25 stocks too.
> 
> ...


Matters what the rules are.
I do think $500 positions are too small.

I also question why you quoted "investing".


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## OptsyEagle (Nov 29, 2009)

The problem with mechanical investing (rules based or whatever name one wants to use) is the guy in charge of it. Namely you. Whatever mechanical strategy you look at you will undoubtedly want to see some backtested data before you use it. 

Two problems arise with this. The first is a concept known as data mining. That is the situation where if one sits at a computer long enough and sifts though enough data, one will inevitably find relationships that have worked better and better then what you are currently using. Not only does this cause one to keep tweeking the strategy, but also increases the chances that the strategy you are using was nothing more then a fluke. The 1 in a million flukes are out there. With a fast computer and time on your hands, it won't take you too long to find them. They look a lot like the ones that are not flukes ... with just a little higher backtested rate of return.

The 2nd problem with backtesting is that the strategies where their results have shown good "recent" performance, will be the ones that look like they have the best long term performance, as well (this is no different then mutual funds where recent performance can significantly boost long term numbers). When you review almost any mechanical strategy you will undoubtedly find many periods of time where the strategy did not outperform, just buying an index or some other strategy. Since it outperformed in the long term, many investors tend to ignore this and want to use it in the hope of obtaining those long term results. The problem is, when the bad year or bad years come immediately. If you get underperformance out of your new strategy in the first year and next for example, it will be very unlikely that you will stick with this strategy for even that length of time. 2 years is about 500 stock market trading days where you get to see a simple index kicking the behind of what you are doing. If you breathe and pulse blood like any other human, you will undoubtedly tweek this strategy or abandon it completely, long before it starts to work. Since most of the strategies that will look good to you will have some recent outperformance, the likelihood of it underforming in the near term becomes much higher...leading to its abandonment or tweek as previously discussed.

So, long story short. Mechanical strategies are designed to take the human element out of the investing process, however, it is the human element of selecting and continuing with the mechanical strategies, that will keep investors from ever benefiting from them.

IMHO you should simply buy an index fund and forget about it. You will do much better...as long as you don't keep trying to find a better index funds. We humans never stop messing things up, do we?


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## GoldStone (Mar 6, 2011)

^^^ OptsyEagle made some razor sharp observations.

Confession time:

I tried an experiment last year. Real dollars. I sold my entire VTI position in Dec 2012. I replaced it with an 18 stock screened portfolio. I used a free screen published by a great investor I trust. The screen has a great track record. It's a purely quantitative strategy. No human judgement is involved. The guy uses Bloomberg to run the screen; data quality is not a concern.

The portfolio performed beautifully out of the gate. 3 months later, at the end of Feb 2013, my portfolio was 9% ahead of VTI. 9% outperformance in 3 months. Brilliant!!

The month of March wasn't as kind. The portfolio became extremely volatile. 3% up days followed by 3% down days. By the end of March, the portfolio gave back 6% of outperformance. It was only 3% ahead of VTI. I chickened out and sold. Locked in the 3% bonus and went back to the safety of VTI. 

And that's too bad. As of this Friday, the screened portfolio is up 36% since inception. VTI is up 26%.

OptsyEagle got it exactly right: _"Mechanical strategies are designed to take the human element out of the investing process, however, it is the human element of selecting and continuing with the mechanical strategies, that will keep investors from ever benefiting from them."_


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## amitdi (May 31, 2012)

MrMatt said:


> Matters what the rules are.
> I do think $500 positions are too small.
> 
> I also question why you quoted "investing".


Because of 2 things -
1) Time horizon should be at least quarter. Ideally annual so that I dont have to give daily attention.
2) I will be always IN the stocks, no matter how high or low the market is.

Its easy for the discussion to turn into a trading method which this is not.


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## amitdi (May 31, 2012)

From what I read from the replies above, there are multiple things to consider (roadblocks if I may call that)


1) Choosing a good screener
2) Backtesting the screener
These 2 need a lot of time and some money for DIY investors. 


Trying to play devil's advocate here. How about choosing one of WWoWS? or some other book where the analysis and backtesting ha been done. If you like one of them, then good . If not, then spend time and money.



3) Discipline - One of the cliches of stock market. "GoldStone" confession was an interesting read...
Its easy to say that I would forget the portfolio for rest of the year, but I know a lot of us (including me) will track it everyday and might consider selling it if it is 40-50% up.


4) # of stocks 
5-10 is too less for these kind of portfolios and with more than 20 and even $1K per stock, your overall portfolio becomes $20K. Can you put $20K towards this?

5) Also to consider is a hybrid approach like "Canadian" pointed out.

I will read the "The Little Book that..." and do some more thinking. But thanks a lot for all your replies till now.


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## MRT (Apr 8, 2013)

20k towards 10 stocks is a LOT more reasonable than your other two scenarios of 10k in 10 or 12.5k in 25.

Consider the trade fees you will incur. Without a certain minimum in your brokerage account, you may not qualify for the lowest trading fee. 

Even at $10/trade, you spend $100 and $250 to set up the 10 and 25 stock portfolios in your initial two examples. That represents 1% and 2% of each portfolio's value, and you then need to earn slightly more than that just to get back to square one. At least with 20k in 10 stocks, you're now down to 0.5% cost. If you are revisiting the portfolio each year, then you may be incurring two more fees each time you sell and buy something else. 

If your trade fees are higher than $10, then these numbers are even less favourable.

Especially when the portfolio is small, you may want to focus on keeping expenses as low as possible until there is more $$$ to invest. The larger your portfolio, the less of a drag trading fees will be on your returns.

With 10-20k, I would be considering index mutual funds, like TD's e-series of funds. Otherwise, I would look at the less complex Canadian Couch Potato portfolios and invest in no more than half a dozen index ETFs.


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## liquidfinance (Jan 28, 2011)

$500 is too small. $2k each and you have a viable plan. 

The hardest thing will be sticking to the rules as the emotions run wild.


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## Xoron (Jun 22, 2010)

GoldStone said:


> I chickened out and sold. Locked in the 3% bonus and went back to the safety of VTI.


This is the bigger problem with mechanical strategies. The ability to stick with it, even when it under-performs for long periods. Is there something wrong with the strategy (IE chicken out and sell it) or is it a small slump? I think with most mechanical strategies, your time horizon has to be years, not days or weeks or even months. 

Who cares if after 3 or even 6 months you're under water. If the strategy is strong, then stick with it.


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## Xoron (Jun 22, 2010)

liquidfinance said:


> $500 is too small. $2k each and you have a viable plan.


Agreed, I started my mechanical strategy with $1800 / stock (6.95 commissions). Now I've moved up to about 2,000-2,100 per stock. Anything less is not worth it (commision, plus FX).


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## 1.5M (Apr 21, 2012)

This is not worth it. It's just maximizing past returns using more and more complex formulas. It has no predictive power for the future. It's the equivalent of Technical Analysis but using some economic data as input, instead of only price data. Useless. Some strategies will beat the market (some by a lot), some will lose, on average will just match the market on the long run. 
Good for brokers and exchanges though, as it generates fees.


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## Jay3 (Jul 16, 2013)

Rule #1

Buy low, sell high.


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## jcgd (Oct 30, 2011)

Jay3 said:


> Rule #1
> 
> Buy low, sell high.


Isn't that rule as insightful as saying if you make a bet, make sure you win? It doesn't actually offer up any actual process, help, or any other means of actually helping a person buy low and sell high.


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## Jay3 (Jul 16, 2013)

It was a joke, a bad one apparently!


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## scomac (Aug 22, 2009)

OptsyEagle said:


> So, long story short. *Mechanical strategies are designed to take the human element out of the investing process, however, it is the human element of selecting and continuing with the mechanical strategies, that will keep investors from ever benefiting from them*.
> 
> IMHO you should simply buy an index fund and forget about it. You will do much better...as long as you don't keep trying to find a better index funds. We humans never stop messing things up, do we?


I wanted to highlite and reiterate OptsyEagle's sage words. The single factor that will determine your success as an investor is how you control your emotions. It's not about being smarter than everyone else, it's about being steady. You have to learn to ignore the noise. The biggest problem that I see with inexperienced investors is that not only do they not ignore the noise, more often than not, they are completely wrapped up in it! Sadly, it would appear, that the only way learn how to deal with this is through first hand experience, because you really don't know how you will react until you are under fire. You can't learn it in a book or a classroom.

Another thing to remember is that the ultimate form of mechanical investing is to buy the total market on a cap weighted basis as cheaply as possible and then hold it passively over time. That's the great contradiction, isn't it? Eschewing one form of mechanical investing for another.


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## lonewolf (Jun 12, 2012)

Actualy emotions are your friend when it comes to investing. Failing to not understand that which you are thinking is the real enemy.

Mans can not keep all his knowledge in his conscious mind. In order to survive he has to make instantanious appraisal such as lunging out of the way of a truck that his traveling @ high speeds in his direction & is about to run him over. His subconscious mind bypasses any lengthy thought process & fear causes him to act instantly by lunging to safety. This is the function of emotions.

If a person did not value life or did not understand that a truck could destroy that which they value they would not lung to safety.


Most investors are living in a sea of self doubt & confusion on how to proceed with thier investing because they dont trust in thier own eyes & simply follow the herd. Each time the herd comes up with a differnt approach they think they found the holy grail. 

When an investor has a strong commitment to reason, has the precise values needed to be successfull playing the market. emotions & the mind will work in harmony helping to make the investor successfull long term.


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## Feruk (Aug 15, 2012)

Even at $2000/stock, you're wiping away your investment on fees. Let's say it costs you $10/trade, right there on the buy/sell you've wiped away 1%, and that's excluding any exchange of currency fees. However, lots of people who have under $50K portfolio might pay $25/trade. So instead, you're now giving away 2.5% in buy/sell fees excluding any exchange of currency fees. Horrible! 

Honestly, if you don't have a portfolio in the $50K-$100K+ range, I don't believe you should be looking at buying even ONE individual stock. All ETFs and other investments. If I don't have $5K to open a position, then I'm either selling something else or not even considering buying the stock.


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## Franky Jr (Oct 5, 2009)

O'Shaughnessy has some mutual funds that try to track his research, the rip off MER would probably be close to what your trading costs add up to. DIY takes lots of time and you have to beat the index by the amount of your transaction costs, so it's kinda like a mutual fund where you start every year down 0.5-2.5% depending on investment amount.


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## jcgd (Oct 30, 2011)

Jay3 said:


> It was a joke, a bad one apparently!


Sorry, wasn't attacking you. A lot of people say its a rule. I'm attacking the rule.


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## Toronto.gal (Jan 8, 2010)

jcgd said:


> A lot of people say its a rule. I'm attacking the rule.


You're right, because it's easy to say that in hindsight. However, we also know that many investors do the opposite, and that's no rule, but a fact.


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