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Losing Money With Winning Strategies

When choosing a mechanical investing strategy, base the decision on the strategy's merits and your ability to stick with it -- not on recent returns. Applying short-term thinking to successful screens is a recipe for underperformance. If you think volatility will shake you out of a screen, consider using multiple strategies to smooth the ride.

By Moe Chernick
August 22, 2000

One common mistake of new Workshop investors is that they chase the stock screen that has the best recent results instead of selecting and sticking with a strategy based on the merits of the screen, its long-term risk, and how it fits into their overall, long-term investing strategy.

Results for these investors are usually disappointing, as they move in and out of various strategies -- often at the worst possible time.

Let's look at how chasing returns can turn two great mechanical investing strategies into a net loss. Because I am using actual results, I will start this example on November 30, 1998. On that day, Investor A (let's call him Alvin) invested $50,000 in a Foolish Four variation. Investor B (Bob) invested the same amount in the RS-IBD Monthly strategy. (In a monthly strategy, the stocks are renewed every month, rather than yearly as with the Foolish Four.)

By April 9, 1999, Alvin's $50,000 was worth $55,200 -- a respectable 10.4% gain. Bob's $50,000 did much better, however. His portfolio was worth an incredible $111,600, a gain of 123%. (Yep, that RS-IBD was hot!)

Alvin begins to question why he invested in the Foolish Four when he could have been making big bucks in RS-IBD. So he makes the move and switches his money out of the Foolish Four and into RS-IBD.

Fast-forward six weeks. Alvin is having heart palpitations. The RS-IBD Monthly strategy is showing a 14.5% loss since he made the switch. His original $50,000 investment is now worth only $47,195, a net loss of 5.6%. Alvin is now thinking of putting his money back in the Foolish Four. Why? Because while RS-IBD dropped 14.5%, the Foolish Four went up 11.9% over the same period. If he had stayed in the Foolish Four, his $50,000 would now be $61,765, a gain of 23.5%.

By changing strategies in midstream, Alvin lost $14,570. Bob, however, is still doing great despite the price drop. At $96,775, his $50,000 is still up an incredible 93.6%.

The above example demonstrates the importance of having a good plan and a long-term perspective. Alvin was focused on short-term results. He took two winning screens and chased his way to losing results. He didn't have a plan, or -- at the least -- he was not carrying out his plan with conviction.

This example also demonstrates why using multiple screens is a good way to get market-beating returns while reducing your volatility. Enter Investor C, Charlene. She also started a $50,000 portfolio on November 30. She decided on a mix of 50% value stocks and 50% high-risk growth stocks. To meet that goal, Charlene invested $25,000 in the Foolish Four and $25,000 in RS-IBD Monthly.

By April 9, Charlene's portfolio had climbed to $83,350 -- not as good as Bob's, but much better than poor Alvin's. Of course, Charlene stuck to her plan, and on May 21, after RS-IBD's drop, her portfolio was worth $78,550 for a net gain of more than 56%. While Charlene's results were not as good as Bob's, she still had tremendous returns and much less volatility. Between April 9 and May 21, Charlene's portfolio went down by $4,800, compared to Bob's loss of $14,825.

Of course, there's no guarantee that following a plan won't generate losses, especially in the short-term. But, your chances of coming out ahead are far better if you make a plan and stick to it than if you chase the latest, greatest returns.

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