How To Build A Portfolio – NOT!

This article is from the AAll Weekly Blog. It’s point is that you need a stock screen to initially select stocks that meet your criteria (who is to say your criteria is viable?)

 But choosing a good strategy is only the first part of a quant’s journey to investing success. The other piece involves going from screen to real-life portfolio. And that’s when things can get tricky.

Don’t Mistake a Good Tool for a Magic Wand

Many of history’s most successful investors have used screens as part of their approaches.

Screens let you identify little-known companies you would otherwise overlook. They force you to consider solid companies whose short-term problems might normally scare you away from a good investment. They let you exclude certain types of companies that you don’t want ending up in your portfolio—those with high debt, for example, or those that are bleeding cash.

But there are a number of things that stock screens don’t do. They don’t tell you how long to hold a stock. Nor do they tell you how many stocks to hold. They don’t tell you how to maintain diversification, how to deal with liquidity issues or how to break ties when more stocks pass your screen than you want to hold. They don’t tell you how trading costs will impact your returns, and they don’t tell you how taxes might eat into your profits.

The good news is that some quantitative investing gurus, including James O’Shaughnessy and Joel Greenblatt, have offered excellent examples of how you can go from screen to reality. From personal experience, I can tell you that it is possible to make the screen-to-real-life leap. To accomplish this, however, you need to put in some hard work up front, you need to be very disciplined and you need to demonstrate mental flexibility.

These are things most people DO NOT WANT TO DO!

Laying the Groundwork

The first step in turning a stock screen into a portfolio management system is, of course, choosing a screen. Given how many screens are available these days, that’s no easy task.

One key point to keep in mind when choosing a screen is to ensure that it has a track record of real-world performance. Backtesting can be a good tool, but backtests can be flawed, and you don’t want to build your portfolio on something that works in theory but may not work in reality.

It’s also important to choose a screen that you believe in—one that makes intuitive sense to you. This isn’t because such screens produce better results. In fact, sometimes screens using variables that seem quite logical don’t perform well over the long term. No, you should use a proven screen that makes intuitive sense to you so that you’ll be more likely to stick with it when the screen goes through a down stretch—and all strategies do go through down periods.

You’ll also need to choose whether to use an absolute or relative ranking system with your screen. An absolute system means that you only buy stocks that meet 100% of your screening criteria; if no stocks meet the criteria at a particular time, you don’t buy any stocks. If more pass an absolute screen than you want to buy, you will need to narrow down the list based on a specific metric. A relative ranking system means that if not enough stocks pass all of your criteria, you round out your portfolio with the next-highest-rated stocks. I’ll explain how to do this in more detail in a moment.

Managing Risk

Once you have chosen a screen and decided on an absolute or relative ranking system, you’re still not quite ready to start filling out your portfolio. For one thing, you need to layer in some risk-management controls.

Allowing any one holding to have too great of an impact on your portfolio can be dangerous. Unless you want to take on quite a bit of risk, you need to hold enough stocks to diversify away stock-specific risk. How many stocks does that take? Studies have shown that the answer is anywhere between 10 and 50, so you have a pretty wide range to work within. This is really a question of personal preference. If you are a more aggressive investor or if you want to put more of your money into your top screening ideas, a portfolio of 10 or 15 stocks might be appropriate. If you are more conservative and risk-averse, you may want to go with a portfolio of 30, 40 or even 50 stocks. After that, however, the benefits of additional diversification seem to be minimal.

Of course, if you put 90% of your funds into one holding, you are taking on a tremendous amount of risk no matter how many stocks you own. To prevent that from occurring, you can equally weight your holdings. Equal weighting is particularly advisable if you are running a more concentrated portfolio. (Over time, the weightings within the portfolio are bound to get out of whack. But we’ll deal with that in just a bit.)

One final risk management consideration involves liquidity. When trading stocks, a degree of “slippage” can result in indirect trading costs. This involves a market order getting executed at a worse price than expected; the more illiquid the stock, the worse the slippage can be. Slippage is a nasty little surprise—you think you’re getting a stock at one price when in reality you get it at a less attractive price. Because of that, you may consider setting certain liquidity requirements (both in terms of a minimum market capitalization and minimum daily dollar value requirements) in your screens. Yes, this can cause you to miss out on opportunities in the micro-cap space, where liquidity tends to be low, but having more certainty over your acquisition and sell prices may be worth the trade-off.

The Build-Out

At this point, you’ve laid a lot of the groundwork for a real portfolio. But let’s see what happens when you start filling it up with stocks.

The first thing to know is that there are a number of good websites out there that provide low-cost ways to invest in screens. They include FOLIOfn ( and Interactive Brokers (via Portfolio123, Choose one that you find easy to use and has low trading costs.

Once you start buying stocks, you will find pretty quickly that you need to address a number of issues that can pop up. For example, just as you want to maintain diversification through your portfolio size, so too do you want to maintain a minimum amount of diversification among industries or sectors. An easy way to do this is by setting a maximum percentage of your portfolio that a single industry or sector can make up. So if you set the limit at 40% for a 20-stock portfolio, and your screen is calling for 10 tech stocks to be chosen, you’d pass on the 9th and 10th tech picks and instead take two non-tech companies. This can mean investing in, say, the 21st and 23rd best ideas from the screen instead of the 12th and 15th, but I believe the diversification benefits make it worth it. (To be clear, there’s no magic in the 40% limit; you can use a limit that is higher or lower if you want. The important thing is to stick to whatever limit you set and not make exceptions based on hunches or emotions.)

Another issue you’ll probably run into quite quickly is how to break ties. Suppose, for example, 27 stocks pass instead of the 20 you desire?

One good way to address the issue: Pick a variable that’s particularly important to you—it could be dividend yield, price-earnings ratio, relative strength, etc.—and use that to break the tie. Sort the results by your key metric—relative strength or dividend yield, for instance—and buy the 20 stocks that are the most attractive based on that metric.

Another issue you will run into—you hope not too often—is what to do when one of your holdings suffers a sharp decline but its fundamentals remain good enough to merit its inclusion in your portfolio. These situations can indicate that something is very wrong with the stock that is not being captured in its fundamentals, and you can address them through stop-loss limits. Many investors set fixed stop-losses—that is, they sell a stock when it falls by a predetermined, fixed percentage.

The Big Question

That brings us to perhaps the most important issue of portfolio management: when to sell a stock that hasn’t hit a stop-loss trigger. Some of the greatest investors of all time have holding periods of years (think Warren Buffett), and studies show that increased turnover often hurts returns while increasing costs. At the same time, the inputs that drive screens can change on a daily basis. You don’t want to get into a situation in which you buy a stock because it has certain fundamental characteristics, then find yourself holding it when those fundamentals have deteriorated sharply.

You also don’t want to let emotions trigger your sell decisions. Sometimes, people sell good stocks of good companies too quickly because they can’t deal with short-term declines or volatility. Other times, they become so attached to their picks that they hold onto a bad stock far longer than they should, hoping in vain that it will rebound and prove their initial buy to have been a good move.

Because selling is so fraught with emotions, some believe in using a regularly scheduled rebalancing system. This means buying and selling stocks only at a predetermined, fixed interval.

In a fixed-interval rebalancing system, on each rebalancing date you run your screen and sell holdings that are no longer passing, or, if using a relative screen, are not among the top-ranked stocks. You replace them with the stocks that have surpassed them on the screen, so that you are maintaining the same number of holdings. In the case of an absolute screen, you replace them with the new ones that do pass. You can also use these dates as an opportunity to bring the holdings in your portfolio back to equal weighting if they have strayed too far.

Whatever time period you choose, the important thing is that you pick a rebalancing schedule and stick to it. Let your buying and selling decisions be determined by the system, not by your own emotions and day-to-day leanings. Over time, this should help you buy low and sell high.

Uncle Sam Complicates Matters

There’s one issue left to tackle, and it’s a big one: taxes. Uncle Sam may provide the greatest example of the difference between running a screen and running a real-life portfolio. Taxes can eat away a huge portion of your gains. But with a bit of work, you can make the tax system work for you, not against you.

Short-term capital gains are taxed at a much higher rate than long-term capital gains. Short-term gains (those earned on stocks you hold for a year or less) can be as high as 39.6%, depending on your income; long-term gains (those earned on stocks held for more than a year) are taxed at a maximum of 20%.

If you are using an annual rebalancing time frame, this tax differential it is easy to address—just push that rebalancing interval to one year and one day. But if you are using monthly or quarterly rebalancing, it gets trickier.

On rebalancing days, look at the stocks that you are due to sell. If the stock has lost money, go ahead and sell it as you normally would, regardless of how long you’ve held it. But if it has generated a positive return, consider how long you’ve owned it. It it’s been more than a year, sell the stock—the proceeds will be taxed at long-term rates. If you held it for close to, but not quite, a year, however, and its fundamentals remain decent, you may want to continue to hold it. This means that you may be keeping a better idea out of the portfolio, but the benefits of holding off a bit on a sale to avoid that big tax hit may well prove worth it.

Gray Is Okay

This tax-management issue illustrates what, for many investors who use stock screens, is the most difficult part of making the leap from screen to portfolio management system: living in the “gray area.” Investors who use screens typically want rules. They know—either from their own experience or from reviewing research—that investors who choose stocks using qualitative factors tend to miss the mark, falling prey to emotional and behavioral biases. Screeners thus want to stick to the numbers to protect them from themselves. If the numbers say that you should buy a stock, you buy it; if not, you don’t. It’s black and white, and in a way, it takes the pressure off of you. Following this sort of quantitative approach lets you invest without feeling as though your own brain is undermining your performance.

When it comes to managing a portfolio, however—even one built using a screen—you’re going to find yourself wading through some gray areas. Inevitably, you’re going to find yourself in a situation in which Stock A, which you’ve held for, say, 11 months and which has surged upward, goes from meeting 100% of your criteria to, say, 75% of your criteria. You’ll probably want to hold it for another month to ensure that those gains are taxed at long-term rates. But what if Stock B—not in your portfolio—better matches the criteria you are screening for? Do you forgo Stock B and stick with Stock A, even though Stock A’s fundamentals have been deteriorating? What if Stock A is passing not 75% of your criteria, but only 50%? Or what if Stock B meets all of the screen’s criteria? What if you are already adding a few stocks from the same industry as Stock A, so that keeping Stock A means you will violate your diversification rules?

These situations are going to occur, and they may make you want to throw your hands up in the air, sell your stocks, and buy an S&P 500 index fund and hold it forever. Don’t overthink it. Yes, you could try to come up with some sort of highly detailed, prepare-for-everything system that employs sliding scales and conditional calculations, but you’re going to drive yourself nuts, and it will be so complicated that you won’t follow it. Instead, I recommend coming up with a simple list of priorities, ranking things like tax efficiency, trading costs, sector/industry constraints, stock score and other factors. When different factors are telling you to do different things, refer back to your priority list and use that as your guide.

Offense & Defense

In the end, screens are a bit like your offense. They’re designed to go out into the investment world and get as many points as possible. Portfolio management is more like defense against the market’s whims, against corporate failures, against Uncle Sam, against your own emotions and biases.

No defense is perfect; it’s inevitable that you’ll give up some points. But a good defense minimizes those pesky gray areas and establishes a framework by which you can deal with the inevitable gray areas that slip through with as consistent and rational a process as possible. If you do that, you give yourself a great chance to win over the long haul.