Why should you follow a strategy

At sharpely, we always tell our investors to follow a strategy-based approach rather than random buying and selling of stocks. What does this mean and why is this important?

This means that investors should focus on creating a rule-based investment approach (a strategy) that focuses on portfolio creation and risk management. Your chance of outperforming the benchmark is always higher if you follow this approach as compared to randomly picking stocks in search of the next multi-bagger.

But before that, let’s discuss some equity investing styles. Note that the styles we are talking about are less along the factor dimension (value, quality, momentum) but more along the lines of portfolio construction methodology.

1. The Warren Buffet Style – bottom-up, concentrated stock-picking

We take the liberty to call this Warren Buffet Style as it closely resembles the legendary investor’s style, at least in the process of portfolio construction. Stock picking logic can vary for different investors.

In this style, investors apply a deep bottom-up analysis of individual stocks to find “good stocks” and build a concentrated portfolio.

The definition of “good stocks” can be different for different investors. For Buffet, it is about “finding discrepancies between the value of a business and the price of that business”. For others, it could be about finding “growing businesses as reasonable valuation”.

But the underlying idea is the same. You build a concentrated portfolio of stocks that are picked by a bottom-up analysis. The concentrated portfolio is the key here. Followers of this style believe that for active stock investing to deliver superior returns, one should build a concentrated portfolio. As Buffet himself states – “Diversification is protection against insurance. It makes little sense if you know what you are doing”.

2. Quantitative factor investing

This is yet another style and is the opposite of the Buffet style in terms of portfolio construction philosophy. This style builds a diversified portfolio (large number) of stocks with exposure to desired factors and runs the portfolio in a rule-based manner. Such strategies also go by the name of smart beta.

The idea here is to (1) define a stock selection model that selects stocks with desired factor exposure, (2) build a diversified portfolio and (3) run the strategy in an automated manner.

3. Random stock picking in search for the next multi-bagger

As the name suggests, this is just trying to find the next multi-bagger either through friends, social media, or worse, paid stock tips.

There is no portfolio, no position sizing, no risk management, no benchmarking. Most of the practitioners don’t even know their XIRR, and forget about benchmarking their performance.

Which style is better?

We can clearly rule out style number 3! The success of Warren Buffet might suggest that style 1 works better than style 2.

But Buffet is an exception.

For style 1 to work consistently and over the long term, you don’t just need great skills, you will also have to work hard. So even if you are a great identifier of attractive businesses (great skills), you will have to spend considerable time (hard work) to find good stocks.

For an average investor, the odds of succeeding with such an approach is low.

However, an average investor, by following a systematic approach (style 2), can considerably increase his/her odds of delivering superior returns. We have multiple evidence (both academic and industry) that systematic, rule-based and diversified portfolios with exposure to the right factors (value, momentum and quality) outperform most of “actively” managed (style 1) portfolios.

Don’t take the word “actively” too seriously here. For all intent and purpose, style 2 is also active management. Although, it generally goes by the name of smart beta.

Back to the strategy-based approach

Here is a crisp definition of a strategy-based approach – following style 2. As a philosophy, we encourage investors to adopt this approach for better long-term results.

For example, on sharpely, we have something called Super Stocks. These stocks are nothing but stocks that are high in quality and momentum and are reasonably valued. At the time of writing this, there were around 100 Super Stocks.

Now we would not encourage users to randomly pick 10 super stocks (no diversification) and but 10 shares of each (no position sizing) in the hope that some of them will turn out to be multi-baggers. In fact, we actively discourage such practices.

Instead, we would like our users to create a strategy (just an illustration) that picks the top 50 super stocks (diversification) sorted by market cap, weigh them equally (position sizing) and rebalance to new stocks every 3 months (disciplined systematic approach with low turnover).

Note that the above example is just for illustration and not a strategy recommendation. The idea is to show the importance of following a strategy-based approach.