Studies of Life

Learning by doing.

How to Know When and What to Sell (or Buy)

29 August 2015 by Jim

I already explained in the previous post how to best sell stocks. I want to expand on that idea a little and show you how the system is really the complete stock portfolio management solution.

Requirements

In order for this system to work, your portfolio needs to be based on a ranking methodology. In my case, a methodology like the trending value system. You need to have some method of ranking the stocks in terms of which are the best and worst to own at any given point in time.

The trending value system developed by James O’Shaughnessy is built on the premises that value/cheap stocks outperform glamour/expensive stocks, and that uptrending stocks outperform those that are downtrending. It uses several combined value metrics to measure cheapness, and the price trend based on the 6 month price change to measure the uptrend. These two factors are then combined yet again, which is easy to do in Excel.

How to rank a list of stocks by combining different metrics

You simply rank each stock individually for every metric using the PERCENTRANK function, and then you average the two ranks (cheapness and uptrend). I personally use 70% cheapness and 30% uptrend in my averageg rank by multiplying the former with 0.7 and the latter with 0.3 before adding them up to the combined score. If you simply average them then you’ll get a 50/50 weighting of course.

So now we have a list of stocks where the forst stocks are the best and the last the worst according to our methodology.

The next step is to buy however many of the top of the list you want – in my case 15-25 stocks for proper diversification. If you can buy more than that without paying too much in terms of commissions, go for it.

How the subsequent selling and buying works

How often do you want to replace your stocks? For me, the answer is once per year. This is, I think, sufficiently often to react to changes in the market, and sufficiently slowly to not generate too many trades. Once per month, I replace one twelth (1/12) of the portfolio. If you want to replace your stocks on average every two years then you just do it every two months instead.

At the end of every month, I rank the stocks in my portfolio the same way that I rank new stocks to decide which to buy next. And then I sell 1/12th of my stocks, the worst ranked ones, and replace them with the best-ranked fresh stocks.

The net result is that my portfolio turnover is 100% in one year, my buying and selling is automated and systematic, my commissions are low, and my portfolio continuously moves toward the best stocks (according to my system) by getting rid of the worst ones and buying the best to replace those. If a stock continuously ranks highly, it can remain in the portfolio forever. If it starts being comparatively worse than the others, it will be eliminated. That’s systematic and intelligent selling. And since the amount of stocks I sell is predetermined (1/12th per month) I do not have to ask myself whether I should sell half of my portfolio during a downturn in the stock market. I’m staying in the market forever, but mostly in the best part of it.

It’s like pulling withered plants out of your garden, and replacing them with strong new flowers. Don’t you just love my drawings? Yeah, me too.

The system prevents me from making intuitive and often wrong decisions, from excessive trading that would cost a lot in terms of commissions, and it produces the portfolio that is closest to what the system recommends.

On a sidenote, it seems value stocks are having a hard time currently, but that’s not surprising since we’ve been in a longer bullmarket so people are becoming less careful. They’re still performing quite well I believe and in the long-term they should outperform, even if it takes a few more years to see it in my own portfolio. Should I find, a few years from now, that my value stocks are underperforming, then I’ll have a new look at the academic opinions. If data consistently suggests that something else is better, I will adapt to that by reducing my allocation to trending value. I’m trying to be rational about all of this, it is not a religion after all.

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