Market Conditions

Market Conditions are uncertain and that is why investing is a careful and deliberate exercise. The market is the ultimate guide. We approach investing when conditions are most favorable. Even great stocks are adversely affected in an adverse market. The models and rules provide directional guidance for the broader market. This assists us to manage the resistance from a headwind, and race with a tailwind. We don’t force our way but accept the market environment and what it is willing to offer. Thus, portfolio exposure is managed based on market conditions and it can be fully invested, partly invested or uninvested.

Stock Selection

Based on the investing focus of the portfolio – industry-specific, index-specific, Small Cap, Large Cap, ETFs – our quantitative-driven stock selection models evaluate companies on various parameters. The process keeps narrowing down the pool of candidates and eventually a ranked list of stocks is generated that represents promising investments within our parameters. Additional criteria is used to eventually select the model portfolio of stocks. The model portfolio stocks are equal-weighted at the time of investment. If a position rises, we do not trim it but let it grow. Consequently, over time, some positions will have a higher portfolio weight as they grow more than the other positions. The models we use are revised at our discretion.

Risk Management

Risk Management is vitally important.

No system can identify all kinds of risk, and there is no assumption of certainty in risk management. We recognize that and have adopted a layered risk management approach to improve our risk management function.

Our various risk management layers include a series of market indicators that determine our entry or exit in the broader market. Even stocks with good earnings and price momentum can get bogged down in adverse stock market conditions. So we are fully invested in the market when conditions are favorable as per our indicators while scaling back based on rising market uncertainty at which time our focus grows towards Return Preservation – not losing what we have earned. Scaling back is relatively easier for individual investors over institutional investors, and it’s an advantage an investor should leverage.

Additionally, we use portfolio diversification in our approach to limit company-specific or unsystematic risk. In the case of non-industry specific model portfolios, we have multiple industries and sectors represented in the portfolio.

Thereafter, we limit the amount we invest in any single stock. Depending on the investment product you subscribe to, such a single position limit can be typically in the range of 8%-12.5%.

As a final risk management defense, we close out a position at the end of the month if it loses its ranking as determined by the models. Sometimes these positions can be running a material loss at the time we close them out. We don’t dwell on it and replace the stock with one that the quantitative models determine to be more promising.

Even all of the above doesn’t guarantee that there will be no blow-ups. That is unavoidable in any stock portfolio. We have had such instances in the past and they will occur again. Recognizing that we cannot avoid losses in some individual stocks, we pursue a methodology of managing the losses, when such situations occur, and focusing on the total portfolio return. As an investor, it’s important to shift risk management towards a portfolio approach from an individual stock approach. Our model portfolios have managed such drawdowns historically and still outperformed the market indexes significantly. The objective of our risk management approach is to diminish the probability of losses and blow-ups while equipping our portfolio to manage the losses when they do occur.

In some products, we may consider using stop-loss triggers to liquidate a position. But in products like the Prudent Biotech Portfolio and the Smallcap Portfolio, where the typical price movement is higher than the broader market, or higher beta, we presently do not adopt stop-loss triggers due to the likelihood of being sold out in the normal volatility or zig-zagging, typical of that industry or market segment.

Also, it is important to note that our systematic investment strategies are developed with the objective of also maximizing returns. Consequently, the model portfolios will be much more volatile than the broader market as represented by the S&P 500 and other indexes. Furthermore, we only reset the model portfolio at the beginning of each month, and consequently, there can be times when the market conditions change faster than our response. However, if market conditions warrant, we will issue updates during the month. In addition, sector-focused products like the Prudent Biotech Portfolio cannot benefit from diversification across multiple industries, and consequently will be more volatile.

Finally, please note that momentum investing strategies are very volatile and not for everyone. One has to understand that there will be sharp changes and the volatility is painful. But with discipline and time, quality momentum strategies based on models can avoid the behavioral biases and significantly outperform the broader market.

Our historical performance reflects all these ups-and-downs.

Disciplined Investing

Wealth Building requires the rigors of Discipline and Patience.

Discipline is a foundation bedrock of Systematic Investing. The best methodologies and plans fail for lack of execution discipline. In times of stress, the system that is designed to manage portfolio losses and preserve gains is compromised by an investor’s inability to execute as per system recommendations. It is a natural human tendency to be pulled into the vortex of emotions – fear, greed, regret, pain – during times of market turmoil. It’s simply hard to detach from such emotions at those critical moments. We have to manage our behavioral tendencies and not deviate from our plan.

Paraphrasing legendary quantitative hedge fund manager Jim Simons, we follow our system slavishly and it has turned out to be a pretty good business.

Discipline is such an important ingredient to the success of our model and investing in general, that we discuss it in greater detail in our section on Systematic Investing, which lays down the case for the merits of pursuing a model-driven investing strategy.