REAP #2 – More on the concept

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This continues the previous post.

 BEST OF BOTH WORLDS – HOLDING AND TRADING

REAP is a trade-off between buy-and-hold, and taking advantage of the “noise” of short-term market movements.  Buy-and-hold strategies have been proven to be very profitable by the likes of Warren Buffett (and my market mentor  Omar Sheriffe Vernon el-Halawani).  The reasoning (and actualization) is that well-chosen stocks of good businesses tend to rise over time from business expansion and from inflation – and it takes time to make big money.   Importantly, because you stay invested, you never miss a market move.  Big moves tend to happen unexpectedly over short periods of time.  When these big moves start and end is nigh impossible to predict with any consistency, so why bother? Just hold and you won’t miss any of it.   REAP features having the portfolio fully invested at all times and in the same names, so nothing is missed, and there is ample time for bigger moves to develop. 

The allocation part has been manifest in strategies such as the “Dogs of the Dow” (where each year you replace your Dow stocks with 3-5 – depending on the Dogs version – with Dow stocks paying the highest dividend at that time.  This strategy is purported to have delivered a total return of something in the order of 18% over time.)  REAP is similar in that it periodically, at a regular fixed interval, calls for a re-allocation.  However you never sell all of a position.  Each REAP six-pack of fixed-name stocks works as a unit, with the recent movers re-cycling some of their relative gains back into the recent laggards at lower prices.  In the short run, this rewards the poorer performers, but each dog has its day, and the laggards at some point have an opportunity to contribute to performance.  Overall, this forced buy-low/sell-high dynamic creates the incremental compounding effect.

STRIKING THE BALANCE

Because each six pack contains only six stocks, 4 of 6 contribute in some way at each re-balancing date – with two partial sales, two buys, and two holds.   Any income also gets re-invested in the laggards.  The reason you sell and buy in pairs is that you don’t want to average down too aggressively on just one stock.  If you only did top/bottom, you may over-invest in a laggard or too quickly rein in a strong performer.  I did a lot of testing, and this arrangement seems to be optimal, or at least pretty darned good.

OFFENSE & DEFENSE

The re-balancing isn’t just about strong and weak stocks.  It is also about creating a flow of investment between offense and defense.  If for example, two stocks in the portfolio are conservative blue chips paying a dividend, and two are a semi-conductor and a bio-tech stock, the latter two will be mostly responsible for the volatility and price-variances in the six-pack. 

In a bull market, the tendency will be that the volatile stocks swing higher than the blue-chips and the money flows into the latter making the portfolio more conservative (and defensive) as the market progresses.  In a bear market the reverse happens, the movers tend to swing much lower than the blue chips, and the money begins to flow from the latter into the former, making the portfolio more aggressive where it should be – near the lows.  In this scenario I call the conservative stocks “anchor” stocks – their role is to stabilize the six-pack and create income from dividends.

NO DEAD MONEY

Basing re-allocation on relative price movements has another beneficial effect.  Suppose a stock gets a bad earningd report and is halved from $20 to $10, and then drifts down to $5.  Dead money, right?  Wrong.  At the substantially lower prices it will likely be the stock involved in a couple of buys, and still have a significant % weighting in the portfolio.  At $5, if that stock goes to $7, that’s a 40% move.  Say at the next re-allocation the next-best stock only went up 20% and the two laggards for that period were each down 10%.  The differential would be 40%+20%-(-10%)-(-10%) / 2  = 40%.  You would still sell 40% of the shares in the now $7 stock regardless of whether that particular sale was profitable or not.  For all you know, the $7 stock might fall back to $4 and one of the 10% laggards may take off = with extra shares from the $7 sale. 

In the short run, selling a stock under water may not be profitable, but in the long run, it all becomes profitable, because in relative terms between the 6 stocks, the overall quantity of share ownership in the companies is increasing, and at some point will pay off.

 SCALABLE WITHOUT LOSS OF PERFORMANCE

Since the compounding dynamic of a six-pack is self-contained, an important – probably the key – feature is that you can take 1,2, 5, 10, or hundreds of six-packs and string them together in a big portfolio – and their performance is additive.  A shrewd portfolio manager at this point might catch on to the implications.  If you stagger the re-allocations in time (and in some cases put big positions in a given stock into more than one six-pack), you can

(a) benefit from the safety of industry, capitalization, and time diversification,
(b) greatly ease the liquidity problems associated with large portfolios,
(c) and not suffer any performance degradation from the diversification.

By staggering in time, I mean re-allocating six-pack on different cycles. Say you have 4 six packs, you could re-allocate GROUP A the first day of Jan, May, and Sep, GROUP B in Feb, June, and Oct, GROUP C in Mar, Jul, and Nov, and GROUP D in Apr, Aug, and Dec.  One six-pack gets re-allocated every month.  You’re not going to miss too much in the market on that cycle.

Using this kind of approach, I can envision creating a huge automatic money-machine that quietly, unassumingly,  taps the random energy of the global financial markets, much like a dam harnesses the energy from a river.   Dare to dream …

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.

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