Clay Allen of Market Dynamics has a fantastic, fantastic essay on the process needed to generate good performance in a portfolio. The process is incredibly simple, but most often ignored.
Surprisingly, the key to good performance is the ability to identify those stocks that are detracting from the performance of the portfolio. Most portfolio managers spend most of their time and effort trying to find the next big winner in the stock market but good portfolio performance depends more on finding and eliminating the bad stocks from the portfolio.
Why is the process ignored? Because most investors do not want to take a loss! This aspect of investor behavior is so ingrained that academics writing about behavioral finance have given the tendency a name, the disposition effect. (If you google for it, you will find dozens of articles written about it.) No doubt the disposition effect costs amateur investors untold millions in aggregate profits every year.
Mr. Allen’s essay is an eloquent restatement of a fundamental principle: cut your losses and let your winners run. The casting-out process used in our systematic relative strength process does exactly that. Each asset has a stop based on its relative strength rank. If it falters in relative performance, it is kicked out of the portfolio and replaced. Mathematically, this is the correct way to run a portfolio. The recent White Paper on our relative strength testing process shows that even randomly selected high relative strength stocks will outperform over time, as long as the weak stocks are knocked out of the portfolio on a consistent basis. Managing the portfolio properly is as important to the ultimate result as the research to find the strong stocks.
