Most professional money managers do not beat the broad market. The majority of mutual fund managers actually underperform their benchmarks in the long and short term.
There are many reasons most investment professionals and novices underperform the market, the main one being human nature. Successful investing requires a lot of discipline. Investment decisions should always be based on the most important facts. Unfortunately, many variables cloud an investor’s mind during the investment process. A few examples include: second guessing trading decisions, gut feelings and opinions in the press.
One solution: mechanical investing
Mechanical investing means allowing a model to make investment decisions. This may sound imprudent. After all, how can a model know what is best? Actually, a model will only be as smart as the researcher who built it. The researcher must design his investment model to incorporate all pertinent variables that should be considered in the investment decision process. For example, if an investor wants to build a stock screening model, she should only include variables in the model that have an impact on the future direction of stock prices. Determining which variables to include is not an easy task. It requires a lot of historical testing using a tool such as the Zacks TSE software or Compustat. Such tools allow researchers to test their investment rules to determine if they would have been profitable in the past. For example, if an investor wants to check if low P/Es really matter, he can test a rule based on P/Es, for instance to buy all stocks when their P/E falls below 5 and sell them once their P/E rises above 10. Software such as Zacks TSE is capable of testing this rule vs. every stock that has ever traded in the last two decades and report how they performed while their P/Es were between 5 and 10. Ideally, a solid stock screening model would consist of several rules that have all been historically tested and that have proven based on history that they have helped screen for top performing stocks.
Creating a mechanical stock screening model is definitely a lot of work. However, it is well worth the effort, as there are multiple benefits. It allows investors to apply the identical stock selection process, time after time, that focuses only on the most important variables, every time they are about to buy or sell a stock. This is discipline at its best! On top of that, once the stock screen model has been designed (i.e. all the variables have been chosen), by using an inexpensive stock screening software or free tools on the internet (such as MSN’s Stock Screener), the investor can determine which stocks meet the criteria with a single click. This is far more efficient than digesting every piece of available information. Not to mention that most stock screeners can analyze thousands of stocks in seconds. It would be difficult for even a large team of researchers to accomplish the same task in weeks.
Most investors including professionals prefer to actively manage their portfolios and to really know their stocks rather than use models. The question to be asked is if this process was so good, why do most investors underperform the market?
Stock screening works because it forces investors to buy and sell stocks without emotion and with discipline, always focusing on the factors that matter using the exact same selection process every single time.
Disclosure: No Positions