As a quantitative value investor, I am sure you have also asked yourself how long I should keep companies in my portfolio?
As you know portfolio rebalancing is an important part of sticking to your plan as a quantitative investor.
If you look at prospect theory in behavioural finance, it says that you should make decisions based on the potential value of losses and gains rather than the final outcome, and that different people value gains and losses differently.
You simply avoid the problem
Luckily you do not have to worry about this, because as a quantitative value investor you outperform the market because of a time tested systematic approach to investing you follow with the Quant Value newsletter.
You simply avoid the – when to buy and when to sell problem – by following a time tested process of buying selected investments and selling them after one year, irrespective of what the return of the companies were during that year.
It makes your life easier
This makes our life easier, because selling is even more difficult than buying investments. And as you know emotions are simply a wrong guide to base your investment decisions on.
Why hold for one year?
The reason we suggest that you have a one year holding period is that most (academic) back test studies were analysed this way.
Joel Greenblatt ‘s Magic Formula , Joseph Piotroski ‘s F-score , James O’Shaughnessy ‘s ‘ What works on Wall Street ‘ tests were all based on a 1 year buy and hold strategy. After 1 year the portfolio is ‘renewed’ with the new list of stocks pouring out of the quantitative models. The main benefit – in some countries- for having a minimum 1 year holding period; is that there is usually a lower (or no) rate of tax on these investments.
We did not just take this as a given
We did not want to simply assume that because everyone else did their studies on a one year holding period is the best so, like all the ideas in the newsletter, we tested it.
This is what we tested (a bit technical)
In this test we looked at three holding periods (3, 6 and 12 months) in the “value and momentum” two factor tests from our back test study. Our primary focus is on the combination of Book to Market (BM) and 6 months price momentum.
Our back test universe was a subset of companies in our database containing an average of about 1500 companies in the 17 country Eurozone market during a 13 year test period (13 June 1999 to 13 June 2012). We select investments on 13 June of each year a list with the 200 cheapest stocks according to their BM ratio (our value factor).
Next we split these 200 stocks in 2 groups according to their previous 6 months performance (our momentum factor): we select the stocks that performed best in the past period and include them in the ‘winner’ portfolio.
Conversely, the stocks that performed worst go into the ‘loser’ portfolio. We measure the portfolio outcomes using 3, 6 and 12 months holding period. During the year (from June to June) we rebalanced the portfolio each quarter or each 6 months based on the 6 months momentum factor and each year on 13 June we also renew our list with the newest cheapest book-to-market stocks.
This is what we found:
Firstly as you can see the strategy we tested works very well delivering very good returns. This is consistent with the research study (mentioned above) and also forms part of the investment model we use to select investments for the newsletter.
Momentum is important
You can also see that price momentum is very important as the ‘winners’ or momentum group of companies performed a lot better than the group of ‘losers’. So winners continue to win...
Six months is best
In the table you can clearly see that the 6 months look back and 6 months holding period is the best of the three periods.
The quarterly rebalanced portfolio was also slightly better than the yearly, but only slightly.
Why we stayed with one year?
In spite of a six month holding period being the best in the Quant Value newsletter we decided on a one year holding period because of transaction costs, not just dealing costs but also the buy sell spreads you have to pay for the smaller companies the newsletter recommends.
If you add the different tax treatment of a one year holding period to a period shorter than that in a lot of countries you will quickly see that a one year holding period is the most profitable.