3. Don’t Mess With the Screens – Human Intervention Hurts Your Performance

Tobias CarlisleStudy Comments

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There are two basic approaches to using the screeners that I call business owner, and quantitative investor.

The business owner uses the screeners as the launching pad for further research, examining each stock the way a classic, fundamental investor would: As a business. The business owner buys a stock in the screener only if it trades at a sufficiently wide discount to a conservative estimate of intrinsic value to provide a margin of safety, and passes otherwise.

The quantitative investor uses the screener to create a portfolio, and relies on the performance of the portfolio as a whole. The quantitative investor buys stocks from the screener without fear or favor, ignoring the particular ills facing any given stock, and ruthlessly play the odds, taking the long-term margin that the screener has offered over the market.

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Both are equally valid approaches, but business owner is by far and away the more difficult of the two. 99.9 percent of investors will be better off as quantitative investors (99.9 percent means one-in-one thousand investors will beat the screen. If I’m estimating incorrectly, I’ll take the under). Consider this: Most professional investors can’t beat the market. (And when I say most, I mean 80 percent of professional investors.)

The reason most people underperform: Cognitive biases and behavioral errors.

Joel Greenblatt has found that investors struggle to implement his Magic Formula strategy using the equivalent of the business owner approach. In a great piece published in 2012, Adding Your Two Cents May Cost You A Lot Over The Long-Term, Greenblatt examined the first two years of returns to his firm’s US separately managed accounts:

“Formula Investing provides two choices for retail clients to invest in U.S. stocks, either through what we call a “self-managed” account [like the business owner] or through a “professionally managed” account [like the quantitative investor].”

“A self-managed account allows clients to make a number of their own choices about which top ranked stocks to buy or sell and when to make these trades. Professionally managed accounts follow a systematic process that buys and sells top ranked stocks with trades scheduled at predetermined intervals.”

“During the two year period under study[1], both account types chose from the same list of top ranked stocks based on the formulas described in The Little Book that Beats the Market.”

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Greenblatt conducted a great real-time behavioral investing experiment. Self-managed accounts had discretion over buy and sell decisions, while professionally managed accounts were automated. Both choose from the same list of stocks. So what happened?

“[The] self-managed accounts, where clients could choose their own stocks from the pre-approved list and then follow (or not) our guidelines for trading the stocks at fixed intervals didn’t do too badly. A compilation of all self-managed accounts for the two year period showed a cumulative return of 59.4% after all expenses. Pretty darn good, right? Unfortunately, the S&P 500 during the same period was actually up 62.7%.”

“Hmmm….that’s interesting”, you say (or I’ll say it for you, it works either way), “so how did the ‘professionally managed’ accounts do during the same period?” Well, a compilation of all the “professionally managed” accounts earned 84.1% after all expenses over the same two years, beating the “self managed” by almost 25% (and the S&P by well over 20%).”

“For just a two year period, that’s a huge difference! It’s especially huge since both “self-managed” and “professionally managed” chose investments from the same list of stocks and supposedly followed the same basic game plan.”

Let’s put it another way: on average the people who “self-managed” their accounts took a winning system and used their judgment to unintentionally eliminate all the outperformance and then some!

Discretion over buy-and-sell decisions in aggregate can turn a model that generates a market beating return into a sub-par return. Extraordinary!

Greenblatt has to be admired for sharing this research with the world. Value investing is as misunderstood in the investment community at large as quantitative  investing is misunderstood in the value investing community. It takes a great deal of courage to point out the flaws (such as they are) in the implementation of a strategy, particularly when they are not known to those outside his firm. Given that Greenblatt has a great deal of money riding on the Magic Formula, he should be commended for conducting and sharing a superb bit of research.

I love his conclusion:

“[The] best performing “self-managed” account didn’t actually do anything. What I mean is that after the initial account was opened, the client bought stocks from the list and never touched them again for the entire two year period.”

“That strategy of doing NOTHING outperformed all other “self-managed” accounts. I don’t know if that’s good news, but I like the message it appears to send—simply, when it comes to long-term investing, doing “less” is often “more”. Well, good work if you can get it, anyway.”

Quantitative investor is by far and away the more boring of the two. Economist John Maynard Keynes famously wrote in his General Theory that “investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.”

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