|
SweetSpot investing -- A cutting-edge approach that takes advantage of the latest findings in behavioral finance and
neuroeconomics...
We're only human after all...
It is now well established that people tend to make bad investment decisions.
Study after study has confirmed it: As a group, investors buy high and
sell low. Whole new fields of academic research have sprouted up to find out
why this is so. Recent advances have shed light on what goes on when
the human animal struggles with questions involving risk.
Scientists can now map the human brain and monitor its functioning in real time. They can actually show
us how tasks involving money and investing cause our "caveman" (and cavewoman) brain to fire on all cylinders. Meanwhile, our rational brain is allowed to function just enough to carry
out directives and think it's in charge. Yet the stock market as we know it has only been around for a couple of centuries.
If it's the caveman brain we're bringing to bear, the human species is maladapted to the stock market...
This explains
investors’ sometimes crazy behavior. We think we're acting rationally but
in reality we're at the mercy of subconscious primal forces. When the news is bad and everyone around us is
selling, those forces are working overtime. Caveman brains are frantically making bad trades...
What to Do?
If we ask
a financial professional how to respond to these new findings, we’re likely to be told, "Don't do that!”
Not much help if our problem is both subconscious and primal. It’s as if
we’re being told that we need to evolve, so what are we waiting for?
Okay, let's evolve.
But how? Ironically, we begin by assuming that most investors won’t evolve anytime soon. Investing is a zero-sum game, with a winner and a loser. If we know that people are making bad trades,
we would be right to take the other side. Maybe our rational brain can overrule
our caveman brain if it only knows why it should. If so, we may be making the next leap forward
in human evolution…
The story that
follows may read like a fairy tale, but it is entirely a work of nonfiction. It concerns SweetSpot, an approach
to investing that directs us to the other side of the bad trades that less-evolved humans feel compelled to make. SweetSpot investors rely on cold numbers to identify the mispriced
assets left behind when the selling is done. Armed with facts, we are able to avoid the pitfalls that
imperil most investors while at the same time positioning ourselves for superior investment returns. Sweet...
The SweetSpot Investment Strategy
Is there such a thing as a high-return, low-risk, hands-off investment
strategy? If so, the people who know about it aren't talking. But maybe we can find out for ourselves...
It's easy
to see that the best time to invest in stocks is at the end of a down market -- prices only go up from there... The end of
a down market is reached when people have been selling for some time until, eventually, the selling is done (or overdone).
The next person who wants to buy will have to offer a higher price. The downward trend reverses and a bottom is formed.
We
want to find that bottom. How do we do it?
First, let's break down our investment universe into about 100 sectors,
represented by several hundred "sector funds." Each sector is moving within its own "market cycle" -- going strong, going
bust, or going nowhere. Then we'll just follow the money. Money moves into each sector and money moves out, like the
movements of the tides. We're looking for the lowest of the ebb tides...
We can find out how much money has moved
into or out of each market sector in the past year. The sectors that saw the most money flow out are our best candidates.
Their supply of sellers is running low, making them the most likely sectors to be at or near their "sweet spots."
The Sweet Spot
The sweet spot is that point in a market cycle where the downward trend
begins to level off. The market is saying something like, "Things can't get any worse and they'll never get any better" (a
silly position to take if you think about it). The human drama has just about played out, dampening the downward pressure.
Even if more bad news comes out, the worst has already been factored into the price so nothing much happens. But if the news
is unexpectedly good, the trend reverses upward and a new market cycle is born:
The Strategy
Let's buy the three sectors with the greatest cash outflows the previous
year, plus any "also-rans" whose outflows were within one percent of the top three. We know that the market has shunned these
sectors -- we may have to hold our noses when we place the trades...
It can take a long time to recover from extreme
circumstances, so we'll give our sectors three years to turn things around. Let's perform the same exercise one year later
with three additional sectors, and again the year after that. At that point we're holding nine or more positions. At the end
of the third year we'll sell the sectors we bought in the first year, using the proceeds from those sales to fund the purchases
for the upcoming year. We're left with a nicely self-perpetuating portfolio that lets us turn our attention to other matters
the rest of the year.
SweetSpot Results
The SweetSpot Investment Strategy has been traded in real time since December
1998. In nine full years of trading it has returned an average of 19.1% each year, [1] compared to the market's average gain
of 4.1% [2]. It's a rare strategy than can consistently beat the market by just a point or two per year. Here the average margin
of victory is 15 points. A back-test performed in 2006 showed market-beating returns going back to 1989, the earliest
it would have been possible to trade the strategy using sector funds. [3]
Looking at each year's picks as one three-year
trade, every trade from 1998-2007 has been profitable and every trade has beaten the market. Furthermore, all individual
positions were profitable and 20 out of 23 beat the market. Consider that the worst bear market since the Great Depression
spanned three of those nine years, and SweetSpot looks pretty special...
HotHands
Once a new market cycle is underway, upward momentum can become just as
relentless as the downward pressure was when a sector was headed toward its sweet spot. Up moves often continue for years,
accelerating powerfully along the way.
Let's buy the three sectors (plus any also-rans) that saw the biggest price
gains last year. We don't want to hold anything that's overheated, so we won't buy a hot sector if it was also among the big
gainers two years ago. We're left with the "HotHands" that are working right now. We'll hold them for one year while they
continue their run and then replace them with the next year's picks.
HotHands Results
A 2006 back-test showed that if we had traded HotHands religiously during
the 18-year period from 1989 through 2006, our average annual return would have been 25.1%, versus 13.6% for the market. A
HotHands component was added to the SweetSpot strategy starting in 2007. [4] The inaugural 2007 real-time HotHands trade
returned +16.5%, beating the market by 11.8 percentage points.
Combined Results
Putting SweetSpot together with HotHands seems to be worth trying... If
we did, at any given time we would be holding a diverse mix of 12 or more funds, roughly three SweetSpot positions for each
HotHands holding. If our portfolio were a mutual fund it would be classified as a "blend" fund: 75% "deep value" and 25% "aggressive
growth."
Long-term back-testing showed that the combined strategies would have returned 18.8% annually, half again
the market's average one-year return of 12.5% over the same period. And we would have earned those returns while taking on
less risk than if we traded either strategy alone.
Risk
SweetSpot looks even better when we subject it to commonly used risk measures,
all of which tell us that our strategy exposes us to less risk than the market. [5] Back-testing showed that we can expect
to suffer through half as many double-digit price drops as the market while enjoying almost twice as many double-digit upswings.
Less pain, more gain...
That's nice, but for most investors the true test of risk is: "Will I lose money?"
It
helps to know that the chances of losing money are far greater when an asset is overvalued, which SweetSpot investments
certainly are not. Still, anything can happen. While SweetSpot has never lost money in real time, back-testing showed
that we should expect to suffer an occasional losing trade. Every now and then, maybe we'll see a chart that looks like this:
After Japan and the Pacific Basin were bought as SweetSpot picks in December
2000, their performance resembled this chart. Yet both positions were profitable by the time they were sold in January 2004,
while the market showed a loss during the same period.
Consider that SweetSpot's reported performance is based on the date a trade
is first entered. Only when the price goes down from there can we improve upon that performance (by adding shares at the lower
"Actual Sweet Spot" price). Maybe we should be rooting for a weak start every time, as long as we're confident
that we'll recover by the time we sell. We can't be certain of that, but we can be reassured by our experience trading
SweetSpot to date. Indeed, given its favorable risk/reward profile, its broad diversification across market sectors,
and its hands-off nature, the SweetSpot Investment Strategy looks like it might be suitable for an investor's entire stock
portfolio.
Will Our Advantage Last?
Great investment strategies
are famous for performing poorly once they come to light. Whatever edge they had disappears quickly and mysteriously. Why
should SweetSpot be any different?
Most of those great strategies
exploited this or that market inefficiency. Once people became aware of it, the
inefficiency was corrected and the advantage that came from it was gone. There
was nowhere to go from there…
SweetSpot investing, on the
other hand, is rooted in human nature; it targets the unchanging human psyche. The
selling frenzies that give rise to distorted asset values are happening every day. We
can trade based on those distortions and then profit after the market corrects them.
Once the value of our investment reaches a level that reflects sanity, we can simply trade it in for whatever people
are going crazy over today…
Our advantage as SweetSpot
investors comes from knowing that we can end-run the madness, using objective criteria to identify the mispriced assets the
cavepeople leave behind after the selling is done. We just do what the numbers tell us, something the rational brain can handle.
In the meantime, we'll be on the lookout for a pickup in the pace of human evolution, which is what it would take for SweetSpot
to lose its edge...
SweetSpot investors -- leading the way in human evolution...
Completed SweetSpot Trades:*
Pacific Basin (fpbfx) bought 12/23/98/sold 12/21/99: +102.8%
(s&p +17.9%) **
Canada (ficdx) bought 12/23/98/sold 12/21/01: +43.9% (s&p -3.9%)
Latin America (flatx)
bought 12/23/98/sold 12/21/01: +16.7 (s&p -3.9%)
Medical Delivery (fshcx) bought 12/23/99/sold 12/28/00: +76.3% (s&p -7.8%)
Food & Agriculture
(fdfax) bought 12/23/99/sold 1/2/03: +23.4% (s&p -35.6%)
Japan (½ fjpnx + ½ fjscx): bought 12/29/00/sold 1/2/04:
+8.8% (s&p -11.7%)
Pacific Basin (fpbfx) bought 12/29/00/sold 1/2/04: +4.0% (s&p -11.7%)
Leisure (fdlsx)
bought 12/29/00/sold 1/2/04: +15.3% (s&p -11.7%)
Industrial Materials (fsdpx) bought 1/8/02/sold 1/2/03: +0.3%
(s&p -20.6%)
Insurance (fspcx) bought 1/8/02/sold 10/15/04: +21.7% (s&p -0.4%) ***
Medical Delivery
(fshcx) bought 1/8/02/sold 1/3/05: +68.0% (s&p +8.6%)
Chemicals (fschx) bought 1/2/03/sold 1/3/05: +74.6% (s&p +36.8%)
Transportation (fsrfx) bought 1/2/03/sold
1/3/05: +68.6% (s&p +36.8%)
Leisure (fdlsx) bought 1/2/03/sold 1/3/06: +70.1% (s&p +46.6%)
Defense
& Aerospace (fsdax) bought 1/2/04/sold 12/29/06: +70.9% (s&p +33.8%)
Energy Service (fsesx) bought 1/2/04/sold
12/29/06: +126.7% (s&p +33.8%)
Environmental Services (fslex) bought 1/2/04/sold 12/29/06: +29.8% (s&p +33.8%)
Automotive (fsavx) bought 1/3/05/sold 1/3/08 +8.3% (s&p
+25.4%)
Industrial Equipment (fscgx) bought 1/3/05/sold 1/3/08 +55.7% (s&p
+25.4)
Materials (fsdpx) bought 1/3/05/sold 1/3/08 +77.9% (s&p +25.4%)
Sweden (ewd) bought 1/3/07/sold 1/3/08 +0.4% (s&p +4.7%)
Spain (ewp) bought 1/3/07/sold 1/3/08 +21.4% (s&p +4.7%)
Singapore (ews) bought 1/3/07/sold 1/3/08 +27.7% (s&p +4.7%)
Annual Performance 1999-2007:
Average annual return: +19.1%
Average annual S&P
500 return: +4.1%
Average annual excess return: +15.0 percentage points
How Has SweetSpot Performed Lately?
In 2007 the combined performance of all
SweetSpot and HotHands positions was +12.7% while the market gained 4.6%.
On January 3, 2008, the 2005-'07 SweetSpot
trade was completed. Collectively, autos, industrial equipment, and materials returned 47.3% versus the market's 25.4%
gain during the same period.
The first-ever real-time HotHands
trade was also completed on January 3, 2008. The combined performance of Singapore, Spain, and Sweden was +16.5% versus
+4.7% for the market. But wait -- China was also a HotHands pick last year. Most SweetSpot investors didn't buy
it, due to concerns about the integrity of that country's economic system. If we had, China's
45% return in 2007 would have increased our overall 2007 HotHands gain to 23.6%, 18.9 points better than the market.
Finally, the 2007-'09 SweetSpot trade
was the first to rely on the data for 500 funds instead of 55. In its first year the trade was up 22.3%, beating
the market by almost 18 points.
*Trades entered on 12/23/98 were based on information provided by Morningstar
and Lipper as reported in the Wall Street Journal in December 1998. Trades beginning on 12/23/99 through 1/3/06 were based
on a proprietary formula using data for all non-diversified Fidelity mutual funds. Collectively, those funds served as a proxy
for the overall market. Beginning in 2007, the formula was applied to data for the entire universe of non-diversified mutual
funds and exchange-traded funds, thus increasing the likelihood that market behavior will be accurately gauged.
Until
2005, a fund was sold a year or two early whenever it strayed too far from its sweet spot. This happened to about one-third
of all positions, beginning in Year One with the Fidelity Pacific Basin Fund. This sell signal was abandoned when both real-time
and back-tested results showed that its use did not materially improve performance and thus complicated matters unnecessarily.
**"s&p" is the S&P 500 Index as reflected by the returns of the Fidelity Spartan 500 Index Fund (ticker symbol:
fsmkx). The S&P's performance corresponding to each trade is reported parenthetically. Results assume the reinvestment
of all dividends and other distributions.
***In October 2004 Fidelity Select Insurance (fspcx) was sold 2.5 months
early when widespread fraud in the insurance industry was revealed. Barring such developments, each SweetSpot trade is held
for three years and each HotHands trade is held for one year.
Notes:
[1] Returns assume the reinvestment of all dividends and other distributions.
Stated returns were achieved by an individual investor who paid no fees other than those imposed by fund sponsors. The information
necessary to trade the strategy is now being made available for a fee, the payment of which would have reduced stated returns
accordingly.
[2] "The market" is represented by the S&P 500 Index, the most commonly used proxy for the broad stock
market, as reflected by the returns of the Fidelity Spartan 500 Index Fund (ticker symbol: fsmkx).
[3] Most strategies
fall short when investors attempt to duplicate back-tested results. Here, however, while the back-test showed a clear advantage
over the market, SweetSpot's real-time results far exceeded what the back-test would have predicted. The back-test merely
confirmed that the strategy would have worked over a longer time horizon than the period in which it has been actively
traded. Still, no representation is made that investors will see profits similar to either actual or hypothetical past results.
[4] The HotHands component of the SweetSpot strategy began trading in real-time in January 2007. All performance figures
for HotHands prior to that are based on back-tested results, which have certain inherent limitations. Unlike an actual performance
record, simulated results do not represent real trading. They don't account for the likelihood that an investor will exercise
his or her judgment (for good or ill) in the face of a changing investment climate. Designed with the benefits of hindsight,
simulated trading often paints a rosy picture of a strategy's prospects. Given recent advances in behavioral finance,
we now know that back-tests have even less predictive value than previously thought because they wrongly assume that the rational
brain is in charge of investment decisions.
[5] An investment's "standard deviation" is a measure of past ups and downs.
SweetSpot's is slightly lower than the market's (that's good). But this measure has a flaw: it penalizes an investment for
both upswings and downswings. SweetSpot fares even better when we measure risk after filtering out the upswings that investors
find desirable.
There is also a measure called the "Sharpe ratio" that attempts to reduce risk to a number. Here a
higher number is better, and SweetSpot's is 0.89 to the market's 0.53.
Disclosures:
SweetSpot Investments LLC is a registered investment adviser. The company's
principal member is Neil Stoloff, a former federal environmental lawyer and a student of investing for over 25 years. Neil
publishes The SweetSpot Investment Letter, an annual publication with updates as warranted. Neil currently has all of
his investable assets invested in the SweetSpot Investment Strategy.
Trades for the SweetSpot Portfolio are executed
only after an email identifying them has been sent to subscribers (see Subscriptions, below). The SweetSpot Portfolio's
past record is reported here. Information available only to subscribers that would identify current Portfolio
positions is omitted.
Disclaimers:
None of the information presented on this website or in The SweetSpot
Investment Letter constitutes a recommendation that any particular mutual fund or exchange-traded fund, portfolio of funds,
transaction, or investment strategy is suitable for any specific person. To the extent any such information is deemed to
be investment advice, it is impersonal in nature. The SweetSpot Portfolio's past results are not a guarantee of similar future
performance.
How To Invest:
The SweetSpot Portfolio usually has a substantial portion of its
holdings invested in Fidelity Select sector funds. Fidelity funds are often subject to surcharges when purchased (if they
can be purchased at all) at brokerages other than Fidelity Investments. Therefore, the best way to invest in the SweetSpot
Investment Strategy is through an account with Fidelity or another brokerage that offers Fidelity funds free of
surcharges. SweetSpot Investments LLC receives no compensation from Fidelity Investments (or any other broker or fund sponsor) in
exchange for recommending its funds or services.
Subscriptions:
An annual subscription to The SweetSpot Investment Letter costs $375.
Charter Subscribers (those who subscribe before Thanksgiving 2008) are eligible for a special discounted rate of $220. Payment
can be made online using Fidelity BillPay, or sent by check to:
SweetSpot Investments LLC
6484 Maple Hills Dr.
Bloomfield,
MI 48301
USA.
Questions or comments should be directed to info@sweetspotinvesting.com.
|
