In the "Zero score and 7 years ago" thread I mentioned in passinga simple technique that I use for position sizing, which started a big digression.http://boards.fool.com/Message.asp?mid=26522554&sort=wholeSorry about that, cerruti!Since the digression raised some questions, I thought I'd post theresponses as a fresh thread since others might be interested.It started with my brief comment"I'm using a simple technique to get a great price: I justcheck every day or two and ensure that the dollar value of my holdingis constant, buying more on dips and selling a little on rises.This ratchets down the average cost basis, and gets me an entry closeto the bottom price---a great technique, provided the thingyou're buying is well supported by value."Zee asked Is this a simplified version of Robert Lichello's AIM technique?Any comments on AIM? (I have the book here, ready to read...)I was doing this before I heard about AIM, and was of course struckby the similarity and bought the book, which I've just about finished.(for "get rich quick" books I have a habit of reading the chaptersin random order, so I'm never sure when I've finished the book).Tpoto kindly sent me his spreadsheet.My first reactions are(a) what an execrably written book. But of course this has nobearing on the ideas being proposed.(b) it really does seem to be a very effective way of ensuring thatyou have an absolutely safe experience being in the stock market overany combination of years, good bad or indifferent. The end returnscome out OK. But, the system is extraordinarily conservative, andyou can wind up well over 80% cash for years at a time. I thinkmost MI folks would find that maddening.(c) so, you end up trying to tweak it. Of necessity, this cuts backon its biggest charm, which is its extreme resilience and safety.There is a nice web site all about AIM at aim-users.com and a veryconcise summary of AIM at this page http://www.aim-users.com/aimbrief.htmThis site has a pretty sensible tweak which simply puts a soft capon the cash allocation. When the cash allocation gets above a certain percentage, you add a bit to the "portfolio control" figure.As an example I've tried (in a monthly-checking series), if thecash allocation gets above 60% then add 5% of the current portfoliovalue to the "portfolio control" value.I haven't really played around with the AIM formula enough to saymuch more about it, or how it might be improved, but another thingswhich seems at first blush to improve returns a bit is a value for "safe" which is smaller than the recommended 10%. But the originalformula as presented has rather more subtlety in it than is apparentat first blush, so this kind of tweak is like a random stab in the darkwithout testing it on a wide range of possible price paths.Certainly the one tweak which seems to make sense to me (which in thebook is discussed briefly but not recommended) is running multipleAIM portfolios, each with its own cash allocation. This makes senseto the extent that your investment choices are uncorrelated. Eachportfolio could be a single investment, or a collection of them.As it gets down to one per investment, that's where is becomes moresimilar to what I have been doing.Which leads to Steve's questions...1. What percent of all stocks would end up being in the following baskets?A. Cost basis is actually ratcheted down as buys / sells are entered where you get in at a lower price each time than what you sell at.B. Cost basis is increased as one ends up re-entering at higher and higher prices. This would seem to be the norm in any bullish market.C. Cost basis remains static -- the rules are such that you act on them but little to no improvement, or loss, results.Worst case for this system is a long, smooth price rise, since that'sthe only time the system underperforms the underlying stock. Of course, this is just fine for your pocketbook. Worst case for your pocketbookis a long period of smoothly sliding prices, but of course you workas hard as you can to pick something that will eventually rise again,at which point the system has added a lot of value for you.Situation B can't really happen, since you never buy on a price rise.Rather, you would be doing a continuing series of small sales (allof them profitable, incidentally) but underperforming the securityitself because you are gradually liquidating a lot of stock belowthe (unknown) end of the stock's rally.In short, as long as there is a bit of jaggedness, the system gives short run price improvement whether the price trend is up, down, or sideways.What happens is that, if your position is underwater, each down-ratchetincreases your average cost basis a bit on each sale, and each up-ratchet reduces it a bit on each purchase, with a ratcheting down effect. If you graphcurrent average cost basis to date as a function of how many shares you own, you get a jagged descending squiggle with each jag sloping downto the right. This is my graph for my (losing) holding in EWJ, with themost recent situation represented as the green dot:http://www.stonewellfunds.com/EWJ.jpgConversely, when your position is in a profit situation, your averagecost basis goes down on sales and up on purchases, so the zigzagsslant the other way. This is a graph of my (winning) holding in BNI:http://www.stonewellfunds.com/BNI.jpgIf the price is crisscrossing back and forth from being a winningposition to a losing one, you get a scalloped look. This is mygraph for my position in USB:http://www.stonewellfunds.com/USB.jpgWhat you can glean from these graphs is that the zigzags graduallydescend in all cases, meaning that you get price improvement oneach pair of trades whether you're in a winning or a losing situation.Sounds perfect, right?Well, what it doesn't show you is the longer cycle: over time you are buying a lot more stock as the price goes down, and selling as it rises. So,it's important for it to be an investment that you definitely WANTto own more and more as the price goes down. For example, I'm fairlycontent to own more and more Japanese equities right now, even if theydon't move in price for a long time, since I think the cyclically adjusted fair value of EWJ is something like $18.00, not today's $12.71.The graphs also don't show you that during a long steady rise yourposition is shrunk much too soon, so you underperform the stock during those periods. The way I think of it is that you've movedsome of those profits in time to the help fill in the bad periods.2. What are the exact (clearly defined and repeatable) rules that you are using to pull this off?For most of the stocks I'm doing it with, it's exactly as described, no more.On a regular basis, check to see how much your stock holding differs from your target amount, and buy or sell the difference to set it right. About the only extra things to decide are:(a) what minimum trade you consider worthwhile. I like lots ofactivity in order to keep myself from doing other, more harmful things, so I often use around $1500 as a minimum trade size. Each zigzagmight make me about $40, and cost $1 in commission.(b) what maximum purchase you might make on a stock. Say you're doing it with a stock that really does have a problem. Maybe somethingyou bought at under half book value, and you *think* is going tostay in business. MTH is my example here. You need to realize thatthe price can keep going down forever, and you don't want to buyan infinite amount of stock, so you have to set a cap. One sensiblecap might be twice the number of shares you started with, because the price has halved in value. If it goes lower, just ignore anybuy signals. If it comes up higher again, act on the first sellsignal and you're back off to the races. This has happened to me.(c) how big your original purchase will be. If you're going toincrease the size of the position later on, you need money to do it with.So, you either have to leave cash on hand, or be willing to use margin.(d) somewhat less obvious, you have to commit a lot of money to a stock.If your position size is small, only very rarely will you trade,and your you won't get advantage from short run noise.That's the simplest version, and what I'm using for most positions.But, there are always endless ways to tweak things.If you want to be more aggressive, you can pick other formulae thatexaggerate the amount to buy and sell. You'll get out of the positionentirely at a price not too much above the current one, and loadup a really huge amount on a moderate drop. This might be appropriatefor an undervalued sector ETF which isn't going to go to zero.A sample formula: first, pick a price "P" at which you want to own a certain amount of stock "SIZE". I picked "P" above today's price andbelow what I thought the fair value was.Then, your position size could be set as SIZE * ((P / pricenow)^2)This is the formula I used for XLF recently, and it has worked very well.Of course, the very best formula is one which takes into account yourestimate of the true intrinsic value (IV) of the stock. (For anyone notfamiliar with the term, here are some notes of min on the subject:http://boards.fool.com/Message.asp?mid=25863464 )If you have a good estimate of today's intrinsic value, you have a much better handle on how much stock is sensible to own. I like thisformula: Leverage = 2 * (intrinsic value / current price ) - 1This is a good formula for values anywhere near or below the intrinsic value, since it will aggressively pump money out of the noise. It needsto be capped at both ends, though, especially on the upside. Froma sensible theoretical point of view, the correct amount of stockto own if the price is above intrinsic value is zero (or short it!).For one stock in particular, Berkshire Hathaway, I calculated the "optimal" ratio using a time series of intrinsic value estimates.I simply used the (very good) figures from here:http://www.creativeacademics.com/finance/IV.htmlPick the "conservative" setting in the pull-down box. Historically it has not paid to own any Berkshire stock when the price is more than 4% above the value that this gives you, which would be $4898*1.04 = $5094 per B share today.This is my original write-up on the "optimal" formula I developed.http://boards.fool.com/Message.asp?mid=25860173This is a revised, much simplified version of about the same thing.http://boards.fool.com/Message.asp?mid=26187879This post provides some data on Berkshire's performance based on the ratio at purchase time:http://boards.fool.com/Message.asp?mid=26214512So, what formula should you use? The very best is this: estimate theunderlying intrinsic value of the security. Figure out how much ofit you would buy today at a series of different hypothetical marketprices staggered downwards from there, and pick any simple formula that roughly matches that curve. The "constant dollar portfolio" rule is simply one such curve, based on the idea that at half fair value you want twice as much stock.3. Are you including trading costs in your evaluation of this strategy?Yup. I use IB where commissions are pretty much always $1, so itisn't really a big issue as long as the minimum trade size isrespectable enough. Obviously it's a strategy that likes stocks which are liquid. I have been doing it with some stocks which are not very liquid, so I have a check for that. For example, if it says it's time to buy, I put in the *ask* price and see if it still says to buy (considering minimum trade size), and if so I place the order at market. That way, the decision is made also taking into account the bid/ask gap.4. What would be the optimal screen for selecting stocks suitable for this approach?Ah, now that's a tough one. I'm not sure I would go about it with a screen.I have been hand-picking the things I put into it, since the criteriaI mentioned are not well suited to automation. The ideal candidatewould include all of the following:- First and foremost, a firm support on value. An intrinsic valuewhich is not going to go down, ever. You're potentially going to bebuying very large quantities of the stock on big drops, and holding ontoit for several years of being underwater, so (as far as is possible) youwant to know in advance that the drop is irrational and temporary.To quote the immortal Mr Graham, Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management.Thus, the main criterion you need is the profitable sustainability of the underlying business activity, less so the current situation.- Something which zigs and zags in price a lot. A very high averageratio of monthly high to monthly low would be a good criterion.JNJ might be a nice company, but its price line is awfully smooth.However, if you can avoid it, long-lasting downswings are not good.- Liquidity.- Low correlation to the other picks (medium to long cycle correlation)- Did I mention that it should be firmly supported by value?- Good general safety criteria can't hurt. I like the one "long termdebt is less than five years' profits", since it means the firm canprobably weather a very bad period and survive.- Good long term prospects, the usual Buffett criteria. The techniquedoes NOT particularly improve the long run results, it just makesthem safer and steadier, so you want a firm that has high andsustainable margins.An ideal candidate which I like right now is Wells Fargo (WFC). It is very undervalued right now, extremely capably and safely run, ithas been fairly volatile, and its long run returns are similar tothose of Berkshire itself, with years of steady growth ahead of it.It's the only AAA rated bank in the US, one of only a few in the world.I believe the value of the firm has been rising at a fairly constantrate in the last decade (using long run estimates), so I think it isa significant buying opportunity that the current price is 2.1standard deviations below its log trend since mid 1997.A couple of months ago I was buying heavily when it exceeded -4.3SD.I have been holding the dollar value of my position steady usingthe simplest rule since Dec 5th, and have improved my average cost basisper share by a pinch over 7% since then. The stock has gone down, so I am in a loss position, but hugely smaller than it would otherwise have been.I own 2.89% more shares than I did then, and my total skin in the game(net of all purchases and sales to date) is 3.86% lower than if I hadsimply been buying and holding since that date.Quite aside from any "price improvement", I believe the more fundamentalreason that this is a valid approach is that it makes economic sense.The size of every position should be proportional to how undervalued thestock is at the moment. Risk is proportional to the ratio of priceto intrinsic value, so risk rises as the price rises.Jim
Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management.
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