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In the recent column "Adding Your Two Cents May Cost You A Lot Over The Long-Term" Joel Greenblatt found that individual investors who put their own spin on the Magic Formula-selected stocks dramatically underperformed a portfolio of the entire Magic Formula list. These investors did so by picking and choosing stocks from the Magic Formula list of cheap and good stocks instead of just selecting all of them or by changing position sizing over time. Pickers and choosers lagged the default portfolio by almost 25% in the two year period between May 2009 and April 2011. By adding their own filters to the Magic Formula rules, these investors turned a winning formula for outperformance into underperformance relative to the S&P 500:

Cumulative Returns May 1, 2009 to April 20, 2011

Portfolio

Return

Raw Magic Formula

84.1%

S&P 500

62.7%

Magic Formula with Investor Selections

59.4%

Professor Greenblatt classifies the self-destructive tinkering of investors into four behaviors:

  • Investors avoided the scariest stocks. Many of the stocks with the highest returns were boycotted by tinkering investors because the future outlook for the firm was too dire.

  • Investors changed strategies when their portfolios underperformed the market. This is the investing equivalent of envy: Nothing is worse than seeing your strategy underperform the broader market.

  • Investors changed strategies when their portfolios lost money. Losing money hurts and investors switch strategies when they feel pain.

  • Investors added to winning positions. Retail investors invested more money after their holdings did well. Unfortunately, this is "chasing returns" masquerading as prudence.

These tinkering investors were overwhelmed by cognitive biases. They should not avoid the scariest stocks since they cannot know the future and their intuitions are not superior to the financial metrics the Magic Formula is based on. Tinkerers should also resist the temptation to time the market in reaction to past performance since this investment strategy is not a momentum strategy.

Mental Toughness and Today's Magic Formula Stock Picks

Consider the following stocks which rank highest according to Greenblatt's Magic Formula:

Ticker

Company

Performance (Last 12 Months)

Analyst Recommendation

Relative Strength Index (14 Day)

AFAM

Almost Family Inc.

-46.3%

3

84.34

AMED

Amedisys Inc.

-70.1%

3.3

60.66

APOL

Apollo Group Inc.

13.2%

2.2

42.38

ASTX

Astex Pharmaceuticals, Inc.

-37.0%

1.5

39.03

ASYS

Amtech Systems Inc.

-62.8%

2.7

44.52

ATVI

Activision Blizzard, Inc.

10.3%

1.8

46.59

CBRX

Columbia Laboratories Inc.

-71.7%

2

34.59

CECO

Career Education Corp.

-53.6%

3.3

62.56

CHKE

Cherokee Inc.

-32.2%

49.77

CJES

C&J Energy Services, Inc.

1.7

75.52

CPLA

Capella Education Co.

-26.8%

2.6

49.3

CRAY

Cray Inc.

4.8%

1.7

65.58

DELL

Dell Inc.

18.0%

2.2

47.62

DEXO

Dex One Corporation

-75.8%

1

41.62

DLB

Dolby Laboratories, Inc.

-23.9%

2.4

67.51

DLX

Deluxe Corp.

1.3%

2.3

54.78

EGY

Vaalco Energy Inc.

12.7%

3

74.46

ESI

ITT Educational Services Inc.

2.8%

2.5

61.09

FFN

FriendFinder Networks Inc.

2

70.95

FRX

Forest Laboratories Inc.

-6.8%

2.6

56.67

GME

GameStop Corp.

17.6%

2.2

45.55

GTAT

GT Advanced Technologies Inc.

-17.8%

2.3

58.93

GTIV

Gentiva Health Services Inc.

-70.7%

3.2

62.05

HRB

H&R Block, Inc.

17.0%

2.2

43.06

IDCC

InterDigital, Inc.

-31.7%

2.8

50.41

KFY

Korn/Ferry International

-29.7%

2.4

42.03

KLIC

Kulicke & Soffa Industries Inc.

13.7%

2

62.68

LMLP

LML Payment Systems Inc.

-52.0%

40.94

MANT

ManTech International Corp.

-14.4%

3.1

57.77

MBND

Multiband Corporation

24.8%

1.7

60.56

MDF

Metropolitan Health Networks

64.1%

2

56.65

MPAA

Motorcar Parts of America Inc.

-44.9%

2

71.43

MRX

Medicis Pharmaceutical Corp.

21.5%

2.5

46.51

MSFT

Microsoft Corporation

19.4%

2.1

76.35

NOC

Northrop Grumman Corp.

-1.3%

2.9

57.1

NSU

Nevsun Resources Ltd.

-35.7%

3

36.06

NVMI

Nova Measuring Instruments

-21.3%

1

41.3

OSIR

Osiris Therapeutics, Inc.

-33.3%

4

34.74

PDLI

PDL BioPharma, Inc.

44.2%

2.8

53.15

RTN

Raytheon Co.

-0.3%

2.4

60.6

SAI

SAIC, Inc.

-21.6%

3.1

55.58

SNDK

SanDisk Corp.

-7.3%

1.9

48.2

TNAV

TeleNav, Inc.

-36.2%

2.8

42.89

UIS

Unisys Corporation

-52.0%

3

47.93

UNTD

United Online, Inc.

-13.9%

2

54.37

USMO

USA Mobility, Inc.

-8.1%

56.71

USNA

USANA Health Sciences Inc.

11.4%

2.6

72.46

VECO

Veeco Instruments Inc.

-41.2%

3

68.11

XLS

Exelis, Inc.

2.5

69.36

Clearly, these stocks tempt investors to tinker with the portfolio! Notice that only six of these stocks have an analyst recommendation higher than three. Since three is a hold rating, most of these stocks are dogs according to analysts. Even scarier, 30 of these stock prices have dropped over the past year. Twenty of these stocks have underperformed the market based on their two week relative strength indices.

Conclusion

Investors should not try to casually time the market or pick stocks based on feelings. If these temptations are overwhelming, investors should not use the Magic Portfolio. However, if an investor is tough (or careless) enough to not tinker, the Magic Formula remains an attractive stock selection strategy.

Please read the article disclaimer.

Source: Behavioral Finance Lessons From Magic Formula Investors