5 Advantages of Mechanical Investing
The Magic Formula is a mechanical investing strategy. What does this mean? Mechanical investing refers to following a discrete and objective set of rules to determine what stocks to buy, and in many cases when to sell them. Most mechanical strategies use a stock screen that uses one or more statistical measures to rank stocks. For example, the Magic Formula ranks all stocks over 50 million in market cap by a combination of earnings yield and return on capital. Mechanical investors then buy stocks that are highly ranked based on these statistics. These mechanical strategies also usually provide for a set period of time at which followers then re-run the screen and re-balance their portfolios based on the new screen results.
Why is mechanical investing an attractive way to invest? Here are 5 main reasons:
Low cost (if implemented smartly)..
Mechanical investing usually involves some turnover in your portfolio a few times a year, but this can be handled easily by individual investors. With commission fees very low at most online brokers, implementing these strategies is very low cost. Using a no-commission fee broker like Zecco, it can be done with no fees whatsoever! Compare this to entrusting your money to an investment professional or buying a mutual fund. Advisers can take several hundred dollars a month in commissions, and mutual funds all come with some overhead, called the "expense ratio". The money saved on these fees greatly improves long term investment returns.
Historical Performance Means Something.
Most mutual fund literature touts their 1, 3, 5, and 10 year returns as marketing for potential investment. The truth is, past performance of managed mutual funds means pretty much nothing. Legg Mason Value, run by famous manager Bill Miller, outperformed the S&P 500 for 15 years up until 2005. Since then, abysmal performance has sent the fund's 10 year return below the benchmark. Fidelity Magellan, a star mutual fund when run by manager Peter Lynch, subsequently underperformed the S&P for over 15 years after he left.
However, with a mechanical investing strategy, historical performance is more meaningful. It is not based on a "hot" stock picker, but on objective measures of valuation and efficiency. They are easy to backtest with historical data. There is never any guarantee that historical results will bear out again in the future. But the likelihood of 50 years or more of market behavior continuing into the future is pretty high.
Several Mechanical Strategies Outperform the Market.
Following the above point, many mechanical strategies have been shown to vastly outperform an investment in the S&P 500 over long periods of time. Most of these are value oriented strategies such as buying low P/E stocks, buying high dividend yield stocks, low price-to-sales ratios, etc. A great book that lists long term returns of dozens of mechanical investing strategies is James O'Shaughnessy's What Works on Wall Street.
Requires Minimal Time Investment.
Most of these strategies prescribe re-balancing the portfolio just a few times a year. In many cases, once a year suffices. Because of this infrequent buying and selling, and because stocks are selected directly from a screen, the time investment required is extremely low. No time is needed digging into SEC filings, listening to conference calls, glazing over balance sheets and cash flow statements, and so on. For that matter, no time requirement to learn how to do these things either! Beating the market while barely trying is a great argument for following a mechanical investing strategy.
Removes the Emotion from Investing.
This is the single greatest reason to follow a mechanical strategy. In the investing game, emotion is your worst enemy. It causes investors to buy when the market is high, and it causes them to sell when the market is low. Logically, this makes little sense, but fear and euphoria are powerful determinants of human behavior. Mechanical investing removes this from the equation. Cold, hard facts determine your investment choices. There is no risk of investing outside of your plan, hoping to catch lightening in a bottle, only to see your money disappear.
Mechanical investing has a lot of advantages. The two keys to being successful with it are to pick a good strategy and stick to it. With over 30% annual returns over a 17 year period, Joel Greenblatt's Magic Formula is clearly a great strategy. Sticking to it through thick and thin, though difficult, should provide followers with similarly excellent returns in the future.
This said, mechanical investing has it's flaws as well. We'll look at these in the next article, 5 Disadvantages to Mechanical Investing.
MagicDiligence can avoid the disadvantages to mechanical investing while providing the high returns, low costs, and minimal time investment. By doing due diligence on the screened stocks, MD finds the best opportunities and recommends them to members. Take a free 30-day trial and get all of my current selections.
Disclosure: Steve owns no stocks referenced here.
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