One of the big issues with P123 Designer Models is the startup requirement to run the portfolio for 3-months “behind closed doors” before allowing (general) visibility and subscriber signup. This is an issue because this requirement does nothing to improve the reliability or future success of the model and in fact impairs model assessment for potential subscribers. Out-of-Sample testing is simply another form of optimization. i.e. run the model OOS and if the results are poor then delete the model and start again. This is not a problem that can be overcome, it doesn’t matter how much OOS time is allotted, the problem still exists. And the big thing is that the three-month requirement works against potential subscribers because they *** believe *** that the initial positive performance is the sign of a great system.
Another big issue is the perception that DMs can be produced that will work presently and for all eternity. As we all know, or should know, the markets are constantly changing. What “worked” a year ago may not be appropriate in the coming year. While designers can revise a model every 6 months, this feature is meant for minor revisions, not major changes. And in fact, subscribers may get upset if the DM they are subscribed to takes a major change in strategy.
My opinion is that it is inherently wrong to direct subscribers to a strategy that holds 20 or more stocks and “works” over a decade or more in the backtest. The reason is that there will be very few different strategies and subscribers will be required to hold 20 or more stocks from each strategy. the subscriber would generally need to be prepared for duplicate stocks and will have difficulty determining how to handle the duplicates. The solution to this issue is for designers to offer investment strategies that are of lesser scope (number of years backtest and number of stocks). Lesser in scope generally means that there is the potential for many more strategies that subscribers can pick and choose from.
There is no law that says that investors should choose one model only and invest everything into it. The smart investors will realize that it is better not to put all the eggs in one basket. Investors are better off selecting a number of small-scope DMs with low correlation to each other.
Principles to Invest by:
1: Volatility is not your friend
In general, higher volatility means lower performance going forward, regardless of what the backtest seems to indicate. The reason is that if a stock loses 50% in value, a subsequent 50% price gain doesn’t bring the stockholder back to even. The higher the volatility, the worse the performance going forward. For this reason, it is better to hold more stocks than fewer numbers. Volatility is obviously reduced with a greater number of positions. Note that this is in direct conflict with what I said above and will say below. Please be patient and hear me out!
2: Diversification is not your friend
I believe it was Warren Buffett who stated that you should only have 10 holdings. In any case, the more diversification you have, the more mediocracy you will have.
3: Find the balance between volatility and diversification
As you can see, principle 1 and principle 2 are at odds. There is, in fact, a tug of war going on (see attachment below) that results in an optimal number of stock holdings that you can actually determine for a given portfolio based on ranking system (keep buy/sell rules out of it). I haven’t done this exercise for at least 10 years, but when I did do it I generally came up with the optimal number of stocks being 5 for a variety of Ranking Systems over a significant time period, using Sortino or Sharpe as the performance barometer.
Again, keep in mind that is is the optimum for a given portfolio and has nothing to do with the number of stocks you hold in your brokerage account, an entirely different matter. There is no reason to impose a “20 stocks or more” rule on an individual model.
4: Swim Downstream
The advantage of DMs with lesser scope is that the strategy can be articulated easier to potential subscribers without giving away the farm. For example, I offer these two DMs with clearly stated strategies: https://www.portfolio123.com/app/r2g/summary?id=1445554 and https://www.portfolio123.com/app/r2g/summary?id=1439560 .
Such strategies allow potential subscribers to assess for themselves whether or not they will perform in the future. Subscribers should always be looking to swim downstream, not against the tide. Look for DMs that exploit anticipated trends.