08/25/2013 "Risk" depends on what would hurt most to lose

Sector Model	XLU & XLP	-0.74%
Style Model	Small Value
Large Portfolio	Date	Return	Days
CAJ	9/25/2012	-11.05%	333
ABX	4/11/2013	-17.07%	135
TTM	5/6/2013	-10.70%	110
DLB	5/13/2013	-5.71%	103
OKE	6/17/2013	17.97%	68
BTI	7/1/2013	3.14%	54
CLH	7/8/2013	9.43%	47
FAST	7/22/2013	-2.99%	33
VAR	8/2/2013	-0.75%	22
OUTR	8/19/2013	1.12%	5
(Since 5/31/2011)
S&P	Annualized	9.97%
Sector Model	Annualized	23.39%
Large Portfolio	Annualized	28.84%

 

I mentioned the other day that OUTR was the first stock selected with a new screening process.  It’s something of a screen within a screen, and backtests on the sector model show a good bit of added value to the process:

 

The blue line is the S&P.  The red line is the Sector Model we’ve been tracking.  The green line is what the Sector Model would look like with the new process.

This is a fourteen year backtest; however, it’s important to note that the new process would have significantly UNDERPERFORMED over the past two and a half years.  There was a sharp drop right at the beginning of the testing period (just after the models were launched on 5/31/2011), and the revised model would have needed to run for well over a year just to get back to zero.

All of which brings me to the subject for today: no matter what your method, you’ll have periods of good and bad luck.  “Risk” depends on how luck would affect your own trading needs.  If you are putting money steadily into the market, the more volatility the better.  If you are steadily taking it out, the less volatility the better.  If you are rotating like the Mousetrap or letting it ride like Buffett, volatility is nothing but noise.

I know, I know, folks like to quote Fama about risk, but Fama’s theories only work if you are close to retirement age or already retired.  If you have at least 4 or 5 years until retirement, following Fama is one of the most destructive things you can do – second only to trying to time (without an extremely sophisticated model).

So let’s look at volatility.  If you are steadily putting 100 a week into your retirement account, a highly volatile vehicle will cause your 100 dollars to represent a higher percentage of your account when it dips than when it is doing well.  The wobbles will actually work to your advantage and you will make money faster.

The flip side is that if you are retired and you take out 1000 a week, that 1000 will be a greater percentage of your account when it is down than when it is doing well.  The wobbles will work against you and you will lose money faster.

In other words, volatility only increases the effect of whatever you are doing to your account.  If you are adding to your account then volatility adds value.  If you are taking money from your account then volatility takes value away.

So, if you are more than five to ten years away from retirement and someone mentions Fama and risk adjusted returns, you may want to get a second opinion.  Fama is great if you are ALREADY rich and don’t want to become poor.  For us working folks Fama is a disaster.

The rule of thumb is that there is no rule of thumb.  Risk is defined by what is most destructive to lose.  For the rich, it is most destructive to lose capital.  For those who are working, it is most destructive to lose opportunity.

My own model looks for sectors and industries that are experiencing extreme panic.  I won’t even look at a stock in a complacent sector.  So Fama is as far away from my own targets as possible, and his only use is in causing these good values to be even better buys for me when I get to them – because none of Fama’s followers are bothering to look.

Am I a fan of Fama?

Nope.

But I do appreciate his scaring away my competition from the bargains that are out there.

Tim