– By Magic Diligence
We use the Spells in a mechanical investing methodology to generate the results seen in the tracking portfolios.
What exactly does this mean? Mechanical investing refers to following a discrete and objective set of rules to determine what stocks to buy, and in some cases when to sell them. Most mechanical strategies use a stock screen that utilizes one or more statistical measures to rank stocks. For example, the Magic Recipe Spell ranks all stocks over 1 billion in market cap by a combination of earnings yield and return on tangible capital. Mechanical investors then buy a prescribed number of stocks that are highly ranked based on these statistics. These mechanical strategies also usually provide for a set period of time at which followers then re-run the screen and re-balance their portfolios based on the new screen results.
Mechanical investing has both its advantages and disadvantages. Today we’ll look at the former. Here are 5 advantages of mechanical investing:
Low cost (if implemented smartly)..
Mechanical investing usually involves some turnover in your portfolio a few times a year, but this can be handled easily by an individual investor. With commission fees very low (and getting lower!) at most online brokers, implementing these strategies is very low cost. Compare this to entrusting your money to an investment professional or buying a mutual fund/ETF. Advisers often take upwards of 1% of assets a year (not profits) – amounting to thousands of dollars – and managed mutual funds and ETFs all come with some overhead, called the “expense ratio”. The money saved on these fees by investing yourself greatly improves long term investment returns.
Historical Performance Means Something.
Most mutual fund literature touts their 1, 3, 5, and 10 year returns as marketing for potential investment. The truth is, past performance of managed mutual funds means pretty much nothing. Legg Mason Value (now ClearBridge Value Trust), once run by famous manager Bill Miller, outperformed the S&P 500 for 15 years up until 2005. From then until 2011 when Miller left, though, abysmal performance sent the fund’s 10 year return well below the benchmark. Fidelity Magellan, a star mutual fund when run by manager Peter Lynch in the 1980’s, subsequently underperformed the S&P for over 15 years after he left.
However, with a mechanical investing strategy, historical performance is more meaningful. It is not based on a “hot” stock picker, but on objective measures of valuation and efficiency. They are easy to back-test with historical data. There is never any guarantee that historical results will bear out again in the future. But the likelihood of 50 years or more of market behavior continuing into the future is pretty high.
Several Mechanical Strategies Outperform the Market.
Following the above point, many mechanical strategies have been shown to vastly outperform an investment in the S&P 500 over long periods of time. Many of these are value oriented strategies such as buying low P/E stocks, buying high dividend yield stocks, low price-to-sales ratios, etc., although research shows that some growth and momentum-oriented strategies have also generated attractive returns. A great book that lists long term returns of dozens of mechanical investing strategies is James O’Shaughnessy’s What Works on Wall Street.
Requires Minimal Time Investment.
Most of these strategies prescribe re-balancing the portfolio just a few times a year. In many cases, once a year suffices. Because of this infrequent buying and selling, and because stocks are selected directly from a screen, the time investment required is extremely low. No time is needed digging into SEC filings, listening to conference calls, glazing over balance sheets and cash flow statements, and so on. For that matter, no time requirement to learn how to do these things either! Beating the market while not trying too hard is a great argument for following a mechanical investing strategy.
Removes the Emotion from Investing.
This is the single greatest reason to follow a mechanical strategy. In the investing game, emotion is your worst enemy. It causes investors to buy when the market is high, and it causes them to sell when the market is low. Logically, this makes little sense, but euphoria and especially fear are powerful drivers of human behavior. Mechanical investing removes this from the equation. Cold, hard facts determine your investment choices. There is no risk of chasing the latest hot stock or investing fad, only to see your money dwindle away.
Mechanical investing has a lot of advantages. The two keys to being successful with it are to pick a proven strategy and stick to it. There are disadvantages too, which we will cover in a future article.
For those interested in mechanical investing, our Spells follow proven investing strategies, both value-based and growth-based, to offer options for mechanically-oriented investors, and our Business Model Diligence ratings add a piece of qualitative opinion to the mix! Try out our low cost membership today and get full access!
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This article first appeared on GuruFocus.