As in most endeavors in life, quantitative investing requires learning from mistakes. An example I recently encountered involved one of my fairly complex short screens. The idea behind the screen was similar discussed here…. Shorting …. and a Happy New Year, but the execution was infinitely more complicated.
Anyway, this screen was spitting out 5 or so stocks each month when I did my rebalance. Last month, it returned only 2 stocks … I was not too concerned: there’s always variation in the number of stocks returned month to month. However, I decided to increase the allocations to each of these names since there were only two names … and then, one of the names (KPTI) had a +60% month. With an oversized allocation and the large positive return, it certain made its presence felt in my overall portfolio return. Sigh.
No worries – it was an up March 2016, and my longs rallied to yield an overall profit .. BUT …. I was somewhat shaken. I did a bit of analysis on the short screen I was using and found something interesting. like KPTI, a large chunk of stocks returned in my short screen were biotech stocks. This made sense since biotech stocks generally look terrible from an earnings standpoint. In fact, these stocks are designed to basically lose money, until they get far enough in a clinical trials to be acquired by a large pharma company.
Enough biotech companies fail that, even accounting for the few that are sold at a massive gain to big pharma, the backtest on my screen was looking great. However, I was taking large risks on individual bets. So …. I did what any human (seemingly rational) investor would do and just excluded biotech from my short screen.
I had to reduce the other restrictions to get back to a reasonable number of stocks in the portfolio at all times … and it definitely reduced the spikes and cliffs. So I implemented it for my April rebalance – 4 non biotech names.
Seems like a win all around, but somehow I doubt this will be my only post on changing the rules. I also somehow feel my next post on this practice of changing rules won’t be as positive about the practice as this one, but we’ll see.