REAP #1 – The Concept

WHAT IS REAP?

Relational Equity Allocation Program is an investment program that takes advantage of the compounding effect derived from re-balancing a portfolio of securities according to how their prices move in relation to each other.

Another way to think of it is asset allocation and re-balancing, but applied to individual securites rather than whole asset classes as a group (the typical professional approach to asset allocation.)  Using the higher volatility of individual securities, you realize an incremental compounding effect from the repetitive mechanical action of essentially buying low(er) and selling high(er).

HOW IT WORKS

You take 6 stocks that are likely to survive over the long run and invest the full capital in an equal amount in each (no cash left over).  Every 4 months you

(1) calculate how much each has moved as a % – for example +6%, -11%, +25% and so on,

(2) add the percentage moves of the top two, and subtract from them the percentage moves of the bottom two, and divide the total by two to get X%.  (Example: Stock #1 = +22%, Stock #2 = +10%; Stock #5 = -8%, Stock #6 = -16%.  X% = 22%+10%-(-8%)-(-16%) = 56%/2 = 28%),

(3) Sell X% of the shares of Stock #1 and X% of the shares of Stock #2. If additional interest, dividends, or deposits were made since the last re-balancing, add that to the proceeds.

(4) Use half the proceeds (total cash) to buy additional shares of Stock #5, and the other half to buy additional shares of Stock# 6.

(5) Record the current price for all six stocks – to be used as the reference point for calculating performance 4 months from now for the next re-balancing.

The portfolio stays fully invested at all times, not to miss any major market moves (up or down), and always in the same six stocks!

To invest a large portfolio, you simply divide up the capital into as many groups of 6 (“six-packs”) as you want.  Each six-pack however always operates as a unit – independently of all other six-packs.  (There’s an important reason for this I will talk about later.) 

THE POINT

Seriously superior performance.  There is an incremental annualized compounding effect (over simply buying and holding), that is a function of the value X% calculated above.  The higher X% is on average, the higher will be the compounding.   Tests show that this (incremental) effect is about 3% of additional annualized compounding using the slowest of blue-chip stocks, 12-15% for the largest number of runs using more volatile stocks, and has been up to 25% in a few cases.  So if your 6 stocks went up over 20 years on the average 10% per year by just holding, with REAP you could achieve 13% per year with very conservative stocks, and 20-25% per for the typical six-pack, and 30%-35% per year for a few exceptional six-packs.  All without leverage (using borrowed money).  Results did not include dividends or interest.

X% of course depends on (1) the volatility of the stocks involved, and (2) the degree of correlation  (the extent to which they move in the same direction at the same time – your objective is to diversify for non-correlation).  So you do have to think about how you put together your six-packs, but once that’s done – there’s very little else to do.  Your research is done, and the market does your heavy lifting from there on.

 WHERE REAP COMES FROM

 I designed it.  The unique parts are the six-pack concept, and the fact that you base your allocation on relative price movement over a fixed period of time, not on the dollar value of your holdings or the profitability of the individual stocks.  What you are really focusing on is increasing/compounding the number of shares, rather than the dollars.  If you do the first, the second comes naturally over time.

And because you are always working with the price differences between securities, the share compounding effect works no matter what the market is doing – going up, down, or sideways.  (The portfolio dollar value will, of course go down in a bear market, but your share count will be increasing no matter what.)

WHAT MAKES ME THINK THIS WORKS?

I was able to create a simulator to use randomly generated stock price sequences, and isolate the effect using hundreds of runs.  I also back-tested with real stock prices.  The results of the simulations and the testing with real price data confirmed each other.

THE CATCH

This is for the long haul – all my testing was based on 20 years, roughly representing 4-5 market cycles.  There is no free lunch.  It takes time for the compounding to build. 

WHY THE SIX-PACK?

It is a good trade-off between holding and trading.  Every 4 months, 4 stocks trade a bit, and two do nothing.  It combines the advantages of buying and holding (stocks need time to grow, and you never miss a move) and of re-balancing (buying low and selling high to create the compounding).

Another huge advantage of the six pack is compartmentalization.  If you never move money from one six-pack to another (and you never do), a poorly performing six-pack will not drag down the others, and a few really well-performing six-packs can deliver most of the performance for the whole portfolio.  The Titanic sank partly because its compartments were not sealed at the top, and water spilled from one to the next as the ship listed.  Same idea here.  The six packs are how you protect the overall portfolio from sinking, and winning six-packs from being dragged down.

ADVANTAGES

REAP’s advantages are:

• the compounding effect
• you don’t have to predict anything – the market comes to you (you are basically harnessing the random energy of the financial markets)
• much less research (the stock selections are done once at the start, and stocks only need to be replaced after a buyout or bust)
• simple and easy to implement – takes very little time to run
• works for massive professional portfolios as well as individual portfolios (without reducing performance)
• can be easily structured to avoid the liquidity issues large portfolios face
• no stock, even if down significantly in absolute terms, is “dead money” – it can always contribute even if in a lower trading range

I like to think of REAP as passive-aggressive investing …

In posts to follow, I will talk about how to find and match stocks, and build REAP portfolios.

Cheers,
Allocator

Copyright George Parkanyi 2007 – all rights reserved.  The methodology is free for anyone to use.  This material is not be copied without proper attribution.