Week 321 - Managing Risk in a Stock Portfolio

Situation: Risk is the likelihood that the market will move against your position. You can use statistics to estimate the frequency and severity of such a move. That analysis starts by calculating the trendline for weekly price changes over multi-year periods (e.g. 20 years) by using the BMW Method. Looking at the S&P 500 Index (^GSPC), we see that prices have appreciated 4.9%/yr. In the upper left corner of that display, the Return Factor (RF) denotes the 0.68% reduction (or gain) of price at 2 Standard Deviations from trendline, i.e., a 32% loss (or gain). It has happened twice in the past 20 years. Prices rose almost 32% from trendline in early 2000 and fell more than 32% from trendline in 2008. We consistently list that predicted loss/gain for each stock at Column M in our tables, using a red highlight that percent is greater than 2 Standard Deviations from the percent for ^GSPC. For the non-professional, owning shares in such a stock represents a gamble. 

Mission: Screen stocks by using the BMW Method for the 20 year holding period, selecting those that do not appear to be a gamble, i.e., deviate 32% or less from trendline. Exclude any that aren’t in the 2017 Barron’s 500 List. Also exclude any that can’t beat SPY (the SPDR S&P 500 Index ETF) in terms of total return/yr over the past 10 years (Column C in the Table) and price appreciation over the past 20 years. We also exclude companies that don’t have a Finance Value (Column E in the Table) that exceeds that for SPY. Over 90% of the stocks passing these screens are Dividend Achievers. We have excluded the two that aren’t.

Execution: see Table. 

Bottom Line: You’re goal is to beat the lowest-cost S&P 500 Index Fund (VFINX) while incurring less risk, but you can’t do that unless your total return over a multi-year period is 2-3%/yr greater. Why? Because an active trader incurs significant transaction costs and capital-gains taxes, neither of which materially affect returns from VFINX. You’ll need a plan. Start by diversifying your investments and taking Warren Buffett’s advice to dollar-cost average. To keep transaction costs low, you’ll have to “cut out the middleman” and resort to an online service like computershare. It is designed to facilitate dividend reinvestment and dollar-cost averaging. 

Given that a large element of risk is introduced by selection bias, you’ll want to ameliorate that risk by investing in at least 20 companies and taking care to pick companies that have less statistical risk than the S&P 500 Index. This week’s Table has 22 for you to consider. 

Risk Rating (for aggregate of 22 stocks): 5 (where a 10-Yr Treasury Note = 1, the S&P 500 Index = 5, and gold = 10)

Full Disclosure: I dollar-average into JNJ and NEE, and also own shares of HRL, MMM, CNI, and ABT.

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