Last week, the Chicago Quantitative Alliance (CQA) held its annual fall conference. As a member, I was able to attend this interesting two-day event. The presentation I enjoyed the most was a psychology-based talk centered around the reasons why we don't perform our best and how to move toward optimal performance. It reminded me of a book I recently finished titled The Inner Game of Tennis. It's one of those books that have applications that reach much further than the title suggests. So it could have easily been called The Inner Game of Preparing for Surgery, Stock Investing or Anything Else in Life. The basic premise of these psychological performance themes is that we tend to over-think what we're doing and would be better off simply doing. That is, of course, doing only after we've spent hours preparing or practicing to hone our game. Once you are skilled at doing something, just do it. Don't over-think. Over-analysis can cause paralysis. Certain thought processes during analysis could also lead to confirmation bias. Studies have shown that both over-analysis and confirmation bias do impede performance. While it's highly important to do your due diligence on stocks, I do believe too many investors buy into the story and become emotionally tied or mentally committed to a stock. It's fairly clear that one should sell if conditions change, and that's harder to do if you're committed to a stock. You've got to be able to let go of a stock that's struggling or avoid it to begin with if something just isn't right. People also make the mistake of forming initial viewpoints and then only "see" things that confirm their first opinion and ignore items that don't match that preliminary thought. This confirmation bias affects us in all aspects of life, including stock investing. If you bought a stock, you clearly have a favorable viewpoint and will tend to ignore negative aspects that should be heeded. Avoid Potential Mistakes That's why I take pleasure in investing in quantitative strategies. After I've built a strategy that I am confident has a good economic rationale and superior performance, I follow it even if it tells me to sell a stock that I'd rather hold onto. I remove emotion from the process and allow the strategy to drive returns by indicating when to buy and sell. I feel that's one thing that gives me an edge in the market. I don't buy a "story" and am not committed to any specific stock. I simply see them as interchangeable vehicles useful for making money. I believe there are times when investors miss out on profitable opportunities because they're tied to a "story" stock whose price remains stagnant versus buying stocks with true return potential. Remember, a good company is not always a good investment. Also, I don't mind if a strategy tells me to short a well-known company or buy a company I've never heard of before. So quantitative strategies also help remove familiarity bias, which is when one purchases only stocks he of she has heard of and avoids ones that are unfamiliar. In fact, one of the things I like best about quantitative strategies is that they often unearth unfamiliar stocks. These little-known stocks might provide great opportunities for profits because fewer eyes are watching them. How To Just Do It One of the easiest ways to implement a quantitative strategy is though a screen. A screen is a great way to find stocks based on indicators that matter. There is so much information available to investors that it's best to focus your stock-picking on proven ideas. The Zacks Research Wizard allows one to shift through hundreds of different data items to determine which are the most important, and then develop a screen that will identify stocks that meet the desired criteria. Once the screen has been tested to determine profitability, just save it and run it as often as you like to generate your list of stocks. Since the Research Wizard contains a number of pre-built strategies, we'll take a look at Growth and Income Winners as an example. Here's how that strategy compared to the S&P 500 on a historical test from August 2002- August 2012: Those results show that, over time, the strategy significantly outperformed the S&P 500 over the last ten years. The annualized rate of return for Growth & Income Winners was 15% higher with a maximum loss of about half as much as the S&P 500. Now that's impressive! Here's how to find Growth & Income Winners:
- First, create a liquid, investible set of the stocks whose price is greater than $5 and average daily trading volume greater than or equal to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade).
- Select only those stocks with a current Zacks Rank less than or equal to 3. (You want stocks rated at least a buy or hold.)
- Select companies with an ROE higher than the S&P 500 median. (You want higher than average profitability.)
- Next, pick those stocks with a P/E less than the S&P 500 median. (You don't want to overpay for a stock.)
- Then, choose only those with a Debt/Equity Ratio less than 1. (Some debt is good. Too much is a problem.)
- Beta should be less than or equal to 1.00. (Low volatility stocks reduce risk.)
- Finally, select the 2 stocks in each sector with the highest Dividend Yield. (You should be looking for a good dividend as well.)