Probable vs. Possible

January 13, 2016

Good advice from Jim O’Shaughnessy:

Investors should make decisions using the long-term base rates a strategy exhibits—in other words, they should concentrate on what is probable rather than what is possible. If you organized your life around things that might possibly happen to you, you’d probably never leave your house, and when you did, it would only be to buy a lottery ticket. Consider, on a drive to the supermarket, it is highly probable that you will get there, buy your groceries and get back home to unpack them without incident. But what’s possible? Almost anything—it’s possible a plane flying overhead could lose an engine falling directly on your car and instantly killing you. It’s possible another car runs a red light and kills you on impact. It’s possible that It’s possible that you get carjacked and your assailant kills you in the process. You get the point—anything is possible buy highly improbable. It’s only when you think in terms of probability that you will get in your car and go, yet few investors do so when making investment decisions. Our brains create cause and effect narratives after something has occurred that seem to make sense, however improbable the event. Witness anyone who invested in the stocks with the highest sales gains after a great short-term run.

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Embracing Automation

December 17, 2015

The Harvard Business Review has a nice write-up of a McKinsey study looking at the benefits to organizations that automate as many daily tasks as possible:

To pinpoint the opportunities, we have looked at about 2,000 activities that are performed in various occupations across the U.S. economy. We find that, from a technical standpoint, work that occupies 45% of employee time could be automated by adapting currently available or demonstrated technology. However, less than 5% of jobs could be fully automated—that is, every activity could be handled by a machine.We estimate, that for 60% of existing US jobs, 30% or more of current work activities can be automated by with available or announced technologies. In other words, for the majority of US jobs, a day and a half’s worth of activities in each work week can be automated…

…The over-arching implication from our research into automating tasks is that roles will be redesigned and organizations will have to become very good at understanding where machines can do a better job, where humans have the edge, and how to reinvent processes to make the most of both types of talent. The largest benefits of information technology accrue to organizations that analyze their processes carefully to determine how smart machines can enhance and transform them—rather than organizations that simply automate old activities.

Embracing automation has been a hallmark of our work here at Dorsey Wright over the years.  Reading the above referenced study took me on a trip down memory lane as I thought about how automation has changed our business for the better.  When I asked John Lewis, our Senior Portfolio Manager and the person most responsible for automating many of our investment strategies, for feedback on this he gave me the following thoughts:

Automating the investment process allows us to examine a huge universe of securities without needing to have a huge team of analysts.  We can run many strategies and we can follow many different markets (domestic, small cap, emerging, developed, etc….) without having to staff up and get analysts up the curve.  This also helps keep costs down, which is very important as fee compression has been happening since commissions were deregulated in the 1970’s.

Automation has also allowed us to be more disciplined and not let emotion get in the way of the investment process.  That has been one of the largest benefits over time.  We used to do all of the analysis manually, but it wasn’t any better.  You begin to realize that computer rankings are relentless – they never have a bad day or take a vacation.  Day after day you get the exact same unemotional ranking no matter what is happening in the market.

Automating repetitive tasks has also freed up our time to focus on more important things.  You can’t automate everything.  We have a lot of functions that require the time of an experienced person that can’t be automated.  A few examples of this include: new product development, trying to make existing strategies better, and client service.  By automating everyday tasks (like loading data into databases and running ranks and models) we can devote more resources to areas that need experienced people.

We never feel like we are “behind” in the investment process.  When the markets do crazy things, our ranks still run overnight and all of our models are updated and ready for us in the morning.  We are never trying to figure out why something is happening or what we should be doing.  That is a huge deal for that small sample of time when everyone is wondering what they should do.

Nobody likes doing repetitive, clerical tasks day after day so automating them makes for a better quality of life in the workplace.  People are just happier not having to copy column C to column D in Excel every day.  When you have happier people they are more productive.

We’re not far from the time of the year where people get introspective and start making goals for the new year.  It might be a healthy activity to review your business and evaluate what percentage of your time is spent on repetitive tasks.  Automating those tasks may well be the key to taking your business to the next level in the years ahead.

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(Unwarranted?) Pessimism Explained

December 16, 2015

Interesting perspective from Morgan Housel on “Why Your Parents Are Dissappointed In You”:

Baby boomers are disappointed in their children. The younger generation whines too much, feels entitled to success, and lacks the responsibility of their parents, we hear. This is not anecdotal. A Pew Social Trends survey reports, “about two-thirds or more of the public believes that, compared with the younger generation, older Americans have better moral values, have a better work ethic and are more respectful of others.”

Of course, Baby boomers’ parents held their kids in equal contempt. Tom Brokaw’s book The Greatest Generation tells a story of baby boomers’ parents disappointed in their childrens’ lack of values and work ethic. “The morals have changed tremendously,” lamented one. Another’s “only regret is that the lessons of his generation” weren’t passed onto his kids. “The idea of personal responsibility is such a defining characteristic of the World War II generation,’ Brokaw wrote, “that when the rules changed later, these men and women were appalled.”

Decades before, the greatest generation was criticized by their elders, too. Woodrow Wilson, who grew up on horseback, said widespread use of the car promoted “the arrogance of wealth.” The younger generation was criticized for abandoning church, dressing provocatively, and leaving the rigors of farm labor for the ease of factory machines. Modern times stole their grit, as Fortune magazine wrote in 1936:

The present-day college generation is fatalistic. It will not stick its neck out. It keeps its pants buttoned, its chin up, and its mouth shut. If we take the mean average to be the truth, it is a cautious, subdued, unadventurous generation.

This goes on and on, a ritual dating back as far as anyone looks. It’s a time-honored tradition to be disappointed in the younger generation.


Here’s one explanation: Things get better over time. As you see younger generations bypassing problems you yourself dealt with, you become resentful. People can appear lazy when they don’t have to suffer as much as you did. This comes through as disappointment in younger generations who don’t seem to care about the same threats and worries their elders did. 

My emphasis added.  This does remind me of a quote by Thomas Macaulay: “Why when we see nothing but improvement behind us, do we see nothing but deterioration before us.”

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Favorite Warren Buffett Quotes

August 19, 2015

Some of my favorites:

It has been helpful to me to have tens of thousands (of students) turned out of business schools taught that it didn’t do any good to think.

(Warren Buffett, Grant, 1991)

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets.  You may, in fact, be better off knowing nothing of these.

(Warren Buffett, 1996 Letter to the Shareholders of Berkshire Hathaway)

Success in investing doesn’t correlate wtih IQ once you’re above the level of 125.  Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

(Warren Buffett, BusinessWeek 1999)


Photo credit:

Source: Excess Returns, Vanhaverbeke

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Be Water My Friend

July 17, 2015

Trend Following wisdom from Bruce Lee:

HT: Michael Covel

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Quote of the Week

June 24, 2015

From Tadas Viskanta of Abnormal Returns:

One of the mistakes novice investors make is that they think they need to stay on top of all of the news that gets generated. They plow through the Wall Street Journal everyday, spend hours with a copy of Barron’s on the weekend and keep financial television all day. The problem is that there is little correlation between keeping up the financial media and actual performance.

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Champions Don’t Do Extraordinary Things

June 23, 2015

Great insight from Ben Carlson at A Wealth of Common Sense:

Trying to knock it out of the park at all times can lead to poor habits in your investment process. I just finished the book The Power of Habit by Charles Duhigg, who explains why this is the case. The reason habits, both good and bad, exist is because the brain is constantly looking for ways to save energy. Habits allow our mind to rest more often because our actions become almost second nature. What gets people in trouble is that we usually default to poor habits.

My favorite example in the book tells the tale of former NFL coach Tony Dungy. When he was an assistant coach, Dungy was constantly passed over for head coaching jobs. In part this had to do with his philosophy, which was too simple for many organizations:

Part of the problem was Dungy’s coaching philosophy. In his job interviews, he would patiently explain his belief that the key to winning was changing players’ habits. He wanted to get players to stop making so many decisions during a game, he said. He wanted them to react automatically, habitually. If he could instill the right habits, his team would win. Period.

“Champions don’t do extraordinary things,” Dungy would explain. “They do ordinary things, but they do them without thinking, too fast for the other team to react. They follow the habit they’ve learned.”

Dungy was finally hired by the Tampa Bay Buccaneers and it only took him a few years to turn around what was once the laughing stock of the league. The players bought into his philosophy, but it seemed to breakdown in big games:

“We would practice, and everything would come together and then we’d get to a big game and it was like the training disappeared,” Dungy told me. “Afterward, my players would say, ‘Well it was a critical play and I went back to what I knew,’ or ‘I felt like I had to step it up.’ What they were really saying was they trusted our system most of the time, but when everything was on the line, that belief broke down.”

Dungy was fired by the Bucs after a few consecutive losses in the conference championship game (they won it all with Jon Gruden the very next year), but eventually went on to win a Super Bowl with the Indianapolis Colts, who finally trusted his philosophy in the big games.

I had to smile at the part describing how Dungy was passed over for many head coaching jobs because his philosophy “was too simple for many organizations.”  Part of my every day is explaining the concept of momentum investing to potential clients (either individuals, financial advisors, or managed accounts departments) and it is not uncommon for me to hear a similar response, “that’s it, it’s 100% based on relative strength?”  Our investment process is essentially bringing Tony Dungy’s philosophy to portfolio management.  We have built our investment strategies around a proven factor–relative strength—and we have systematized our models so that we don’t have to overthink things.  Yet, many seem to feel more comfortable with something that sounds incredibly complex.

I’ve seen money run non-systematically and I’ve seen money run systematically.  In my view, here are the key benefits to systematizing the investment process:

  • In order to systematize a strategy, extensive research is required to understand what rules should be implemented.  Such testing makes it clear what works and what doesn’t over time.  Quiet confidence is a natural results of completing this research before the first dollar is invested.
  • Stress goes way down.  Simply systematizing an investment strategy does not remove periods of underperformance (unfortunately!).  However, it does make us think much more about process than short-term outcome.  The role of luck becomes greatly minimized and we are much better prepared to weather the inevitable rough patches without making hasty changes to our model.
  • Better results for our clients.  I firmly believe that our client’s lives will be better off because we employ a systematic process.  I believe they will have more money than they would otherwise have and I believe that they are more likely to become comfortable with our investment process and and stay with the strategy for longer periods of time.

So why don’t more people systematize their investment strategies?  Lack of computer programming ability, lack of access to data to do proper testing, lack of self-discipline to refrain from constantly tweaking a good model, and perhaps most of all, searching for the perfect rather than acceptance of the good.  However, if you can overcome those obstacles I believe you will put yourself in a position to be in very select company over time.

A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Average is Over

June 5, 2015

Tyler Cowen’s book Average Is Over provided me some important insight into the ever-changing nature of our global economy—and particular insight into why some financial advisors are seeing their businesses thrive and others are struggling to stay afloat.  Growing income inequality seems to be a hard trend that economists and politicians have debated ad nauseam in recent decades.  Consider Cowen’s take on why this growing disparity is taking place and where we go from here:

This imbalance in technological growth will have some surprising implications.  For instance, workers more and more will come to be classified into two categories.  The key questions will be:  Are you good at working with intelligent machines or not?  Are your skills a complement to the skills of the computer, or is the computer doing better without you?  Worst of all, are you competing against the computer?

…If you and your skills are a complement to the computer, your wage and labor market prospects are likely to be cheery.  If your skills do not complement the computer, you may want to address that mismatch.  Ever more people are starting to fall on one side of the divide or the other.  That’s why average is over.

Surely, we in the financial services industry can attest that this is true.  Those advisors who have embraced technology have likely seen their businesses rapidly expand over the past decade.  They find themselves to be significantly more productive, able to manage much more money with seemingly less effort, and better able to stay connected to their growing number of clients in meaningful ways.  Those advisors who have not embraced technology, still trying to do business the way they did it in years past, are being left behind.

Subscribers of DWA research are keenly aware that there has been a wee bit (ok an enormous amount) of innovation over the years in our research database.  The core PnF principles from decades past are still there (supply and demand still determine price just like they always have).  However, this method that once involved hand charting stocks on a piece of graph paper has been computerized.  Now, our research is focused on rules-based asset allocation models, guided ETF models, and relative strength matrices that allow advisors to customize and systematize their own investment strategies at the click of a mouse.

We have also seen our assets under advisement take giant leaps forward…yet the firm still has about the same number of employees we had a decade ago.  How is this possible?  We are managing money with a reliance on systematized relative strength models which allow for tremendous efficiency and, we believe, better investment results that non-systematized approaches to investing.  Are there still money management firms that employ vast armies of analysts feeding data to investment committees who regularly meet for long meetings to debate investment strategy?  Yes, but those are among the people that Cowen is talking about when he asks, “are you competing against the computer?”

The future is very bright for those advisors who stay on the right side of technology.  For those that don’t, they are going to find it harder and harder to stay average.

A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Making Fewer Decisions

May 14, 2015

RPSeawright makes a very compelling argument for reliance upon systematic models:

At the institutional level, making fewer decisions can mean building an investment process that, in effect, makes the decisions for us. If we carefully and collaboratively build, monitor and continue to evaluate a process that gets us to the decision we need without having to make (potentially a lot of) active preliminary decisions at every step we can improve outcomes, often by a great deal.

So if you want to make better decisions, start by working out how you can make fewer of them.

HT: Abnormal Returns

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Waiting for the Dust to Settle

April 24, 2015

The Irrelevant Investor kills it with this post:

The Worst Investment Strategy Ever


Do you make bad decisions when your portfolio goes down? What if there was a way to automate the decision so that your emotions wouldn’t get in the way. Good news, I found a way!

Here is the strategy, every time stocks drop five percent, you sell and wait for “clarity.” Why would you voluntarily ride out volatility, right? And here is the best part, you don’t get back in until things have stabilized. Repurchase stocks when they are one percent higher than when you sold, just to make sure that the dust has settled. Better be safe then sorry right? Here is what that strategy has looked like since the inception of the S&P 500.


Alright so you didn’t beat the buy and hold investors but you did compound your money at 2.8% with less than a ten percent annualized standard deviation. This is just slightly worse than what the average investor has historically earned, but after adjusting for risk this looks like a great alternative.

End sarcasm

If you want to suppress volatility it’s likely you’ll suppress your returns as well, it’s just that simple. Here is an idea- if you are uncomfortable with equities, pick a different asset class. Notably, five year treasury notes have compounded at 6.6% a year since 1957 with an annualized standard deviation of just five percent. Unless your looking for an equity strategy with bond-like returns, you might want to rethink jumping in and out every time the market takes a dip.

Comfortable doesn’t work in the financial markets if you want to earn equity-like returns over time.  My simple solution (for typical 55ish-65ish+  year old): Divide your portfolio into three buckets.  Income Bucket, Balanced Bucket, and Growth Bucket.  For your Growth Bucket, don’t try to manage the volatility (that is, in large part, what the other buckets are for).  Don’t do something similar to the strategy described above of selling when you feel uncomfortable and buying when “the dust settles.”  Rather, accept that your Growth Bucket is going to have some volatility to it, some drawdowns, some uncomfortable years.  By all means, spend the necessary time (or seek the appropriate financial advice) to put together a well-thought-out allocation for that Growth Bucket, but once that part is done, don’t look at the Growth Bucket in isolation.  Look at it in the context of your overall asset allocation.  Simple advice, but I believe it would lead to much better outcomes than are typically achieved in the financial markets by investors.

Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Nothing contained herein should be construed as an offer to sell or the solicitation of an offer to buy any security.  This post does not attempt to examine all the facts and circumstances which may be relevant to any product or security mentioned herein.  We are not soliciting any action based on this post.  It is for the general information of readers of this blog.  This post does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients.  Before acting on any analysis, advice or recommendation in this post, investors should consider whether the security or strategy in question is suitable for their particular circumstances and, if necessary, seek professional advice.  

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The Fallacy That Bull Markets are Easy

March 12, 2015

Ben Carlson is spot on:

It’s easy to look back on it now and say how much of a lay-up it was to invest at the depths of the market crash in early 2009, but there weren’t too many people saying things were all clear at the time. Investors were scared and constantly waiting for the next shoe to drop. Ever since the recovery started people have been doubting it’s legitimacy. Pundits have been scaring people away with predictions of double dip recessions, hyperinflation and the collapse of the U.S. dollar.

Don’t let anyone tell you investing in this bull market has been easy. It hasn’t, but really, it never is.

A good portion of the money that we manage here at Dorsey Wright is in one of our Tactical Asset Allocation strategies.  One of the key features of these strategies is the systematic way that these models rank a broad range of asset classes and invest in or overweight the strongest asset classes.  We let relative strength dictate whether we are going to be invested in “defensive” asset classes or “offensive” asset classes.  Without a systematic investment process, it’s just as easy to mess up (often by sitting on the sidelines) in a bull market as it is in a bear market.

HT: Abnormal Returns

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Can a Quant Model Be Trusted?

March 9, 2015

Can a quant model really be trusted?

For all kinds of reasons, investment managers tend to find quantitative models to be interesting, but insufficient.  They want to have access to the outputs of quantitative rankings, but then to only use that output as one consideration among many when making the ultimate decision about what to buy or sell.  Not surprisingly, human emotion ends up getting the biggest say.

Maybe, there are some problems with that approach.  Consider the following study (Dresdner Kleinwort Macro Research):

The first study I want to discuss is a classic in the field.  It centers on the diagnosis of whether someone is neurotic or psychotic.  A patient suffering psychosis has lost touch with the external world; whereas someone suffering neurosis is in touch with the external world but suffering from internal emotional distress, which may be immobilizing.  The treatments for the two conditions are very different, so the diagnosis is not one to be taken lightly.

The standard test to distinguish the two is the Minnesota Multiphasic Personality Inventory (MMPI).  This consists of around 600 statements with which the patient must express either agreement or disagreement.  The statements range from “At times I think I am no good at all” to “I like mechanics magazines”.  Fairly obviously, those feeling depressed are much more likely to agree with the first statement than those in an upbeat mood.  More bizarrely, those suffering paranoia are more likely to enjoy mechanics magazines than the rest of us!

In 1968, Lewis Goldberg obtained access to more than 1000 patients’ MMPI test responses and final diagnoses as neurotic or psychotic.  he developed a simple statistical formula, based on 10 MMPI scores, to predict the final diagnosis.  His model was roughly 70% accurate when applied out of sample.

Goldberg then gave MMPI scores to experienced and inexperienced clinical psychologists and asked them to diagnose the patient.  As the chart below shows, the simple quant rule significantly outperformed even the best of the psychologists.

hit rate

Even when the results of the rules’ predictions were made available to the psychologists, they still underperformed the model.  This is a very important point: much as we all like to think we can add something to the quant model output, the truth is that very often quant models represent a ceiling in performance (from which we detract) rather than a floor (to which we can add).

The Dresdner Kleinworth research finds the same conclusions in the realms of baseball, wine, university admissions, and criminal recidivism.  Could it also apply to investment managers?

That is a pretty hard pill to swallow for investment managers, who as a group, don’t lack for self-confidence.  Yet, for those investment managers who truly understand the quantitative model, who built the quantitative model, who have stress-tested the model, and who are using an adaptive factor (like relative strength), strict reliance upon the model may very well represent “the ceiling in performance.”

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Quote of the Week

March 3, 2015

When you talk, you are only repeating what you already know; But when you listen, you may learn something new.  —Dalai Lama

Very applicable to the markets as well.  In fact, I would argue that listening (and reflecting market action) is all relative strength is really doing.

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What You Should Focus On

February 27, 2015

One of my favorite sketches from New York Times columnist, Carl Richards, is the following:


There are a lot of things that matter and there are a lot of things that we can control, but there is a much more limited number of things that both matter and are things that we can control—and that is where our focus should be.

This principle certainly applies to the construction of our investment strategies here at Dorsey Wright. I’ll take one index as an example. Every quarter, we select 100 stocks from a universe of approximately 1,000 U.S. mid and large cap stocks to make up the Technical Leaders Index (used for the PowerShares DWA Momentum ETF—PDP).

What We Can Control

  • We can control the quality of the research that we performed to identify the best PnF relative strength characteristics that will be used to select and weight the stocks for the index
  • We can maintain the integrity of the index construction process from one quarter to the next

What We Can’t Control

  • How those stocks in the TL Index perform after they have been selected
  • World events that might affect the financial markets from one quarter to the next

For Q1 2015, we once again followed the same process that has been followed for the last nearly 8 years in constructing the index for PDP and the following chart shows the current holdings of the index. The chart also shows how these stocks have performed so far this quarter.


(click to enlarge)

Most of the holdings have done quite well this quarter. Some haven’t. The ones that continue to meet our criteria will stay in the index in Q2 and those which have deteriorated will get cycled out and replaced with stronger names. As is our mantra here at Dorsey Wright, we will continue to focus on the right process and the results will take care of themselves over time.

From the perspective of an advisor who is using rules-based strategies, like PDP, I believe there is a great deal of confidence that comes from knowing that the strategy is based upon a methodology that has stood the test of time. Clients recognize and gravitate to advisors with that type of confidence.

Keeping a focus on the right things (i.e. the things we can control and the things that matter) make all the difference in this industry—an industry which is characterized by a flood of distractions at every turn.

Dorsey Wright is the index provider for PDP.  See for more information.  The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  The performance above is based on pure price returns, not inclusive of dividends or all transaction costs.

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Unbending Flexibility

February 12, 2015

I am a man of fixed and unbending principles, the first of which is to be flexible at all times. —Everett Dirksen

That statement encapsulates the paradox of relative strength investing—flexibility and discipline.  In the financial markets, the word flexibility conjures up images of whimsical investment decisions with seemingly different rationale used for every trade.  How different that is to the way that we invest at Dorsey Wright.  We build models that typically have a great deal of flexibility, yet the rationale for every trades is the same—relative strength rank.  We sell a current holding because its relative strength rank has fallen sufficiently and we buy a replacement position because of its favorable relative strength rank.  In other words, we buy strong positions and we hold them for as long as they remain strong.

For example, one of the ETF models available through Dorsey Wright research is the DWA PowerShares Sector 4 Model (Power 4).  This model is designed to gain exposure to the strongest relative strength sectors in the US through the use of the nine Sector Momentum ETFs: PYZ, PEZ, PSL, PXI, PFI, PTH, PRN, PTF, and PUI.  When equities are not in favor, the portfolio can raise varying amounts of cash, up to 100%.  Dorsey Wright is also the index provider for the 9 PowerShares Sector Momentum ETFs.

Power 4 Portfolio Rules

  • Evaluated monthly
  • An inventory is established to represent each of the nine macro sectors.  The inventory consists of multiple representatives for each macro sector.
  • A matrix is created to compare members of the inventory to one another.
  • The sectors and cash are ranked from strongest to weakest based upon their tally rank within the matrix
  • The top 4 sectors are equally weighted
  • At the end of each month, if a sector falls out of the top 4, it is sold and replaced with the highest ranking sector not already in the portfolio.
  • If cash is the #4 slot, it receives a weighting of 25%.  For each slot it moves up, an additional 25% is allocated to cash.  If cash is the #1 ranked asset class, it will receive a 100% weighting.
  • Portfolio changes are transacted in a “replacement” method, and rebalanced only when a position drifts materially from it target allocation.

The start date for this model is 2/19/2014.  We also tested the strategy back to 2002.  Click here for a fact sheet.

Below you will see the historical allocations of the model:

power 4 allocations

Clearly, this is a flexible model.  Yet, the rationale for each of the trades was the same: relative strength rank.

Any virtue, taken to an extreme, can become a vice.  To be flexible is good, if it results in better investment results than a static allocation.  However, if flexibility is taken to an extreme, it can lead to overtrading and poor investment results.  Likewise, discipline is good, but if it results in an inability to adapt to different market environments, it can become a vice.

In the models we build at Dorsey Wright, we make great efforts to find a healthy way to have both flexibility and discipline.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Nothing contained herein should be construed as an offer to sell or the solicitation of an offer to buy any security.  This post does not attempt to examine all the facts and circumstances which may be relevant to any product or security mentioned herein.  We are not soliciting any action based on this post.  It is for the general information of readers of this blog.  This post does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients.  Before acting on any analysis, advice or recommendation in this post, investors should consider whether the security or strategy in question is suitable for their particular circumstances and, if necessary, seek professional advice.  Dorsey Wright & Associates is the index provider for the suite of PowerShares DWA Momentum ETFs.  Some of the performance information is the result of back-tested performance.  Back-tested performance is hypothetical (it does not reflect trading in actual accounts) and is provided for informational purposes to illustrate the effects of the relative strength strategy during a specific period.  Back-tested performance results have certain limitations.  Back-testing performance differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with teh benefit of hindsight.  model performance data does not represent the impact of material economic and market factors might have on an invesment advisor’s decision making process if the advisor were actually managing client money.

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Point and Figure RS Signal Implementation

September 2, 2014

Over the course of the summer we published three different whitepapers looking at point and figure relative strength signals on a universe of domestic equities.  In the first two papers, we demonstrated the power of using PnF RS signals and columns to find high momentum stocks, and then we looked at the optimal box size for calculating relative strength.  If you were on vacation and happened to miss one of the first two papers they can be found here and here.

The third paper examines the performance profiles you can reasonably expect by following a process designed around point and figure relative strength.  You can download a pdf version of the paper here.  Most momentum research focuses on performance based on purchasing large baskets of stocks, which is impractical for non-institutional investors.  Once we know that the entire basket of securities outperforms over time the next logical question is, “What happens if I just invest in a subset of the most highly ranked momentum securities?”  To answer this question, we created portfolios of randomly drawn securities and ran the process through time.  Each portfolio held 50 stocks at all times, which we believe is a realistic number for retail investors.  Each month we sold any security in the portfolio that was not one of the top relative strength ranks.  For every security that was sold, we purchased a new security at random from the high relative strength group that wasn’t already held in the portfolio.  We ran this process 100 times to create 100 different portfolio return streams that were all different.  The one thing all 100 portfolios had in common was they were always 100% invested in 50 stocks from the high relative strength group.  But the exact 50 stocks could be totally different from portfolio to portfolio.

The graph below taken from the paper shows the range of outcomes from our trials.  From year to year you never know if your portfolio is going to outperform, but over the length of the entire test period all 100 trials outperformed the broad market benchmark.

 (Click To Enlarge)

We believe this speaks to the robust nature of the momentum factor, and also demonstrates the breadth of the returns available in the highest ranked names.  It wasn’t just a small handful of names that drove the returns.  As long as you stick to the process of selling the underperforming securities and replacing them with stocks having better momentum ranks there is a high probability of outperformance over time.  Over short time horizons the outperformance can appear random, and two people following the same process can wind up with very different returns.  But over long time horizons the process works very well.

Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  A momentum strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value. 

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Quote of the Week

August 6, 2014

Via Michael Covel, an excerpt from James O’Shaughnessy’s book What Works on Wall Street:

Models beat the human forecasters because they reliably and consistently apply the same criteria time after time. In almost every instance, it is the total reliability of application of the model that accounts for its superior performance. Models never vary. They are always consistent. They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored. They don’t favor vivid, interesting stories over reams of statistical data. They never take anything personally. They don’t have egos. They’re not out to prove anything. If they were people, they’d be the death of any party.

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A Wise Old Owl

July 29, 2014

The essence of relative strength:

A wise old owl lived in an oak.  The more he saw the less he spoke.  The less he spoke the more he heard.  Why can’t we all be like that wise old bird?

HT: Patrick O’Shaughnessy

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Reality Check for Forecasting

July 28, 2014

I’d say this is a pretty compelling argument for trend following.  As shown below, the average strategist forecast for the S&P 500 is routinely way off.


Source: WSJ

Rather than even attempt to forecast the unknowable, trend followers simply stay with the trend, until it is time to move on.  See here, here, and here.

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Unrealistic Paradigms

July 21, 2014

The NYT unintentionally gives a great example of how NOT to analyze active equity strategies:

A new study by S.&P. Dow Jones Indices has some fresh and startling answers. The study, “Does Past Performance Matter? The Persistence Scorecard,” provides new arguments for investing in passively managed index funds — those that merely try to match market returns, not beat them.

Yet it won’t end the debate over active versus passive investing, because it also shows that a small number of active investors do manage to turn in remarkably good streaks for fairly long periods.

The study examined mutual fund performance in recent years. It found that very few funds have been consistently outstanding performers, and it corroborated the adage that past performance doesn’t guarantee future returns.

The S.&P. Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as of March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.)

The team selected the 25 percent of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12-month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.

The answer was a vanishingly small number: Just 0.07 percent of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.

Yes, that is right.  Unless a fund was in the top quartile of performance for each of the four years it was considered a failure.  The premise of the article is that investors should employ index funds unless they can find active strategies that outperform every year.  Talk about setting yourself up for failure!  I am aware of a number of investment factors that have generated outperformance over time (momentum, value, low volatility), but I am aware of nothing that outperforms every year.

The returns of those managers who are able to generate outperformance over time is rather lumpy.  Consider the performance profile of the best performing managers of the 1990’s as an example:

Cambridge Associates, a money management consulting firm, did a study of the top-performing managers for the decade of the 1990s. In 2000, they could look back and see which managers had returns in the top quartile for the entire decade. Presumably, these top quartile managers are precisely the ones that clients would like to identify and hire. Cambridge found that 98% of those top managers had periods of underperformance extending three years or more. 98% is not a misprint!  Even more striking, 68% of the top managers ended up in the bottom quartile for some three-year period and a full 40% of them visited the bottom decile during that ten years. Clearly, there are good and bad periods for every strategy.

Investing is challenging enough without setting yourself up for failure by placing unrealistic expectations on active managers.  I have nothing against index funds.  We use them in a number of our strategies and I think many investors can benefit from using them as part of their allocation.  However, they are not a panacea.

This example is presented for illustrative purposes only and does not represent a past recommendation.  A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Cullen Roche on Michael Covel’s Podcast

July 18, 2014

Listen to the 12:45 – 15:20 mark in this interview.  Cullen Roche has some key comments on pragmatism (something that we discuss regularly at DWA and a concept that separates winning investors from the rest).

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Why Bother With Active?

July 14, 2014

National Geographic makes a provocative claim about longevity on one of its recent covers:


Our genes harbor many secrets to a long and healthy life.  And now scientists are beginning to uncover them.

While it might be a stretch that life expectancy in the US will be approaching 120 any time soon, what is not a stretch is that life expectancy continues to increase.  Among many other aspects of increased longevity, the financial implications of being a good investor are becoming more pronounced.

To illustrate, consider a simple example.  Suppose that when the baby on the cover of the magazine graduates from high school at age 18 he decides to take a summer job selling alarm systems door-to-door.  This boy is a very good salesman, and is able to pull in $100,000 before he heads off to college.  He decides to take that sum of money and invest it in the stock market.  Suppose that this boy ends up never needing to use that money and so throughout his very long life that money just stays invested and is able to earn 9 percent a year.  Compare that return to a different person who, over the same time frame, invests $100,000 and earns only 6 percent a year.

Table 1

With this simple example, it becomes easy to see how greater longevity can have an outsized reward for those investors who are able to generate even a couple percent excess return over time.  After only 10 years of investment results, the investor earning 9 percent a year only has 1.3 times more money than the investor earning 6 percent.  However, after 100 years there is an enormous difference of 16.3 more money.

Something to think about next time you hear someone say that it is not worth it to try to find an active strategy that is able to generate a couple percent in annual excess return over time.

This example is presented for illustrative purposes only and does not represent a past recommendation.  A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Michael Covel Interviews Tom Dorsey

March 31, 2014

Click here to listen to the story of how Tom came to embrace Point & Figure Charting.


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Packaged Discipline

March 21, 2014

With approaches to investing such as is described in the following excerpt from a post on Musing On Markets blog (written by a professor at NYU), is it any wonder that factor-based investing (aka “Smart Beta”) is taking off?

Assume that you value a stock at $20 and it is trading at $30. What would you do? If you are a value-based investor, the answer is easy, right? Don’t buy the stock, or perhaps, sell it short! Now let’s say it is three months later. You value the same stock again at $20 but it is now trading at $50. What would you do now? Rationally, the choice is simple, but psychologically, your decision just got more difficult for two reasons. The first stems from second guessing. Even if you believe that markets are not always rational, you worry that the market knows something that you don’t. The second is envy. Watching other people make money, even if their methods are haphazard and their reasoning suspect, is difficult. You are being tested as an investor, and there are three paths that you can take.

  1. Keep the faith that your estimate of value is correct, that the market is wrong and that the market will correct its mistakes within your time horizon. That may be what every value investing bible suggests, but your righteousness comes with no guarantees of profits.
  2. Abandon your belief in value and play the pricing game openly, either because your faith was never strong in the first place or because you are being judged (by your bosses, clients and peers) on your success as a trader, not an investor.
  3. Preserve the value illusion and look for “intrinsic” ways to justify the price, using one of at least three methods. The first is to tweak your value metrics, until you get the answer you want. Thus, if the stock looks expensive, based on PE ratios, you try EV/EBITDA multiples and if it still looks expensive, you move on to revenue multiples. As I argued in my post on the pricing of social media companies, you will eventually find a metric that will make your stock look cheap. The second is to claim to do a discounted cash flow valuation, paying no heed to internal consistency or valuation first principles, making it a DCF more in name than in spirit. The third is to use buzzwords, with sufficient power to explain away the difference between the price and the value.

The level of subjective decision-making described above is a recipe for ulcers, unhappy clients, and likely a short career in this industry.  Such an investor follows a different discipline (I use that term loosely in this context) every day.  Every change in investment philosophy is largely based on changes in feelings.

One of the major reasons why there has never been a better time to be an advisor in this industry than today is because of the ability to access disciplined investment strategies (aka “Smart Beta”) in rules-based indexes where the risk of the manager not following the discipline is largely removed.  Books, such as What Works on Wall Street by Jim O’Shaughnessy, clearly point out that there are a number of return factors that have been able to generate excess return over time.  In my opinion, one of the biggest reasons that “actively managed strategies” have had such a poor track record, in aggregate, over time is because the investment committee of these strategies sits around and goes through some variation of steps 1-3 shown above on a regular basis.  In other words, there is no discipline! 

Consider the following exchange between Tom Dorsey and IndexUniverse from last year on the topic of the future of the ETF industry.  Tom was asked to explain his statement that the future of the ETF market is “ETF Alchemy.”

Dorsey: Think about this for a second: If I take H2 and I add O, what do I get?

Dorsey: Yes, water. Each one of those two elements is separate. But when I combine the two, I come up with a substance—water—that you can’t live without. Each one separately is not as good as the two combined. And the concept here is, What’s out there in terms of ETFs I can combine together to make a better product?

Take for instance the Standard & Poor’s Low Volatility Index—and if you add that to PDP, which is our Technical Leaders Index, and combine the two, it’s like taking two glasses of water and pouring them into one bigger glass of water, 50-50. I end up with a better product than either one of them separately.

You’ll find this as we go along: the ability to combine different ETFs to create a better unit where the whole is better than the sum of its parts.

A little later in the interview, Tom Dorsey spoke to just how important the ETF has been to the industry:

Dorsey: Yes, and I can’t tell you how many seminars I have taught to professionals on ETFs and the eyes that widen and the lives that change once they understand it and understand how to use it; it tells me we’re on the right path and this is the exact right product.

Like I’ve said to you before, it’s probably the most important product ever created in my 39 years in this business. And I believe back then when I talked to you that we’re in the first foot of a 26-mile marathon.

With some reasonable amount of due diligence, advisors today can identify a handful of investment factors that have historically provided excess return.  The advisor can then combine these strategies—now plentifully available in ETF format—for a client in a way that provides diversified and disciplined exposure to winning return factors at a reasonable cost.

Dorsey Wright is the index provider for PDP.  For more information, please see  A momentum strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Past performance is no guarantee of future returns. Potential for profits is accompanied by possibility of loss.  

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Picking the Winners: NCAA Office Pool Edition

March 18, 2014

The WSJ this morning on how to win your NCAA Office Pool:

Pick the favorites. This is the only foolproof way to guarantee you won’t embarrass yourself.

For all of the attention paid to underdogs—is there any other reason you know Florida Gulf Coast University exists?—the better team still wins most round-of-64 games. Over the last 10 seasons, the average number of double-digit seeds beating favorites was six per tournament. Meanwhile, a bracket with favorites winning every game last year would have placed in the 91st percentile of entries to ESPN’s contest, a company spokeswoman said. In other words, your bracket can only be so contrary until it’s cuckoo.

Part of the fun of NCAA Office Pools is bragging rights of picking the underdogs (even if it’s a statistical unlikelihood).  However, this same principle applies to investing.  When it comes to the financial markets, rather than shoot for bragging rights, go for the money!

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