But what is back testing? It is a process where one takes an idea like investing in low price to book stocks. You formulate a method, for example, that you will buy only price to book stocks in the lowest quintile (20%) on the last trading day of the month and rebalance your porfolio quarterly. Then you test this idea in past period of time. These are usually tested over longer periods. In my post last month about Ben Graham’s Stock Selection Criteria, Oppenheimer back tests the strategy from 1974-1981. In the post on Buying Low Price to Book stocks, Ibbotson back tested from 1967-1984.

I have used these and other academic studies to form the basis of an investment strategy that underpines this website. In fact, it was some of this same back tested research that sparked the idea of 80/20 investing, which I am still developing. But I am not an academic, I am a small time investor. And like many of you, I am really only interested in real returns. So I am keenly aware of some of  the practical limitations of back testing. When I began my research on Graham, years ago, I was puzzled by something. Graham had developed a set of investing criteria. And someone set up a fund that set out to capitalize on this method. The studies show that it should have worked. But it didn’t. The fund had to disband a few years later. Why? What was the disconnect?

So what is the Problem with Back Testing? It turns out there are several Problems for the practical investor.

1) Friction- Friction are the Brokerage Commissions, taxes and bid-ask spread issues that Damodaran referred to. Broker commissions and taxes you can calculate, but because many of the value investing approaches studied deal with small cap stocks that are often illiquid, the difference between the bid for a stock, the amount an investor is offering to buy the stock at, and the ask price, that is the price the seller of that stocks is asking for, can often be quite large, sometimes 10% or more. This cannot be easily calculated in an academic study.

2) Buying on an arbirtrary time frame- For academic research you must attempt measure results over a given time , with specific criteria, but the best deals will not always occur on the end of the month, or once a year.  Rebalancing at mechancial intervals, may also limit your profits, by telling you exit a position too early or too late.

3) Survivor bias- Taleb speaks about this as  a general problem with the investing community in general, and economists in particular. Is the back testing incorporating the number of companies that fit the strategy but failed or when bankrupt?

4) Portfolio limits- If you have a limited investing portfolio such as $5,000, you cannot know going into a year knowing how many opportunities you will have. With such a small portfolio you cannot possibly invest in every opportunity that arises. But that is the very assumption you supposed accept. If 40 opportunities arise, you buy all forty, and if five arise then buy only five. In what proportions? Do you leave everything else in cash?

Are their any solutions to these problems? Some. But not neccessarily solutions that you will be happy with.

1) Friction- There are several ways of dealing with the friction issues. Some I have written about before. For brokerage commissions, select a good discount broker or one that doesn’t charge fees for maintaining a certain balance. Tradeking, my primary broker, charges just $4.95 a trade. Taxes can be controlled by  investing in tax advantaged accounts like ROTH or traditional IRA’s. But bid-ask spreads are a little trickier.  My favorite strategy is to sell on good news. I have noticed that the volume on thinly traded stocks tends to go up when there is good news and investors are trying to buy the equity. Since value investing is also a contrarian strategy, good news is often a catalyst for a price rise and a good opportunity to exit a position. Another tactic is simply patience. Set up flags when a stocks price reaches a certain price. Then put in a limit order. And wait.

2) Buy when opportunities present themselves. Don’t be afraid of cash. It is a better alternative than losing money. I think Graham’s idea of holding for a 50% gain or two years is a good starting place for parameters to frame your investment horizon. But you shouldn’t completely exit a position just because you have reached a 50% gain, if your analysis suggests  a larger upside. Perhaps, in that instance you take a portion of your profits off the table. Two years should be the outside to hold an investment that is not performing. Maybe. If you discover a much better investing opportunity, two years could be too long.

3) Surviving Survivor bias. Look for tools to minimize the chances of a company failing. The most important thing is preservation of capital or as Buffett says, “Rule number #1 is don’t lose money. Rule #2 is don’t forget Rule #1. ” These tools may include the Altman Z score, the Piotroski F score and other more simple financial metrics such as the acid test.

4) Portfolio- Decide how many companies you are willing to invest in. Invest in great investment opportunties when they arise. Keep a Focused Investment strategy. It is possible that if you chose to invest in 8 companies, that after a price drop, one of the companies you have already invested in is the best value, and you should add to your position.

This does not mean a simple approach to investing cannot work. But I am more suspicious of mechanical investing that I was before.

Related Posts:

• Value Investing Ideas – Companies Passing my Custom Screens
• Value Investing Criteria that Works- Low Price to Free Cash Flow (FCF)
• 3 Must haves for your Value Investing Notebook
• Greenblatt, Ackman & Value Investing Masters speak at the Value Investing Congress
• Underperformance in a Fund, Time to Invest?

As Whitney Tilson of T2 investments said, “the overwhelming majority of great investors that I’m aware of practice focus investing. They invest infrequently, only when they’re highly confident that the odds are heavily in their favor, and then they bet big.” Focus investing is the same idea as the Buffett-Munger concept of only swinging at the Fat pitch. As Charlie Munger said at a Bershire Hathaway annual meeting, “If you took out our 15 best ideas, most of you wouldn’t be here..We have this investment discipline of waiting for a fat pitch.” You will get a lot of investment ideas pitched to you. Most you should let go. But when you see a pitch that is perfect for your investing style, one that you understand, one that is right where you like to hit, then don’t hold back and put everything you have into the swing. Finally Robert Hagstrom said in his book, The Warren Buffet Way, “Reduced to its essence, focus investing means this: Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations.”

Focus Investing  is such a fundamental part of my investing strategy, that I sometimes forget it is with me. I have never owned more than 10 stocks at one time, even though I have 3 trading accounts. Sometimes I have had more than one position in a company in different accounts. If it is a great idea, pile on. Every time I look at making a new investment I look at what I have invested in, and I look at the available investments that I am aware of and ask myself the question, is this a better opportunity than one I have already invested in? But more importantly, is it a great investment? Is it an investment idea that has so much going for it that is seems almost foolish not to put my money down.

For the small time investor or beginning investor, you do not have the time or fortitude to track the 30 plus equities that persons who recommend diversification suggest. The fewer companies you own pieces of the fewer places you have to watch for the proverbial ball dropping. You are more likely to understand the company. Focus Investing is ultimately like Value Investing itself. It either makes sense to you or it doesn’t. If it doesn’t try something that does work for you.

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