There's a new artificial intelligence software that has been getting a lot of attention called ChatGPT. Out of interest, I typed into the ChatGPT website - "How do you design a stock investment strategy?"
Within seconds the following text surfaced. (these are the highlights, the answer was comprehensive).
1. Identify Your Goals: Before creating an investment strategy, you should identify your financial goals. Ask yourself questions such as: What are your investment goals? How much risk are you willing to take? What kind of return do you expect? .............
2. Choose Your Investment Options: ..........
3. Set a Diversification Plan: Diversification is an important part of any stock investment strategy.........
4. Monitor and Adjust: .....................
Pretty impressive software, given the simplicity of my question. I asked Chat GPT the question as a follow-up to my last post, Adding Value. Can I really add value through superior stock selection, buying "good" companies and avoiding the "bad"? Or will it prove difficult to beat a passive index.....time will tell.
The strategy's investment goals
Seek to achieve a 20% annual, average rate of return. For comparison, there is an ETF ("MDY") that tracks the S&P 400 Mid Cap Index (#1). This index has annualized at a return of 10.95% over the last 27 years. I think MDY could reasonably be expected to return 10% per year (on average) going forward. So a 20% targeted return is aggressive. In my mind, there is not much point in trying to beat the index by 1% to 2% per year, as a modest improvement in return is not worth the time and effort. You might as well just own the index (a +10% index return being entirely satisfactory).
The strategy has an objective of matching the drawdown of the S&P 400 Mid Cap Index. This mid-cap index has experienced bear markets every 3-5 years, falling in value by +25% (on average). My expectation is that strategy would fall by a similar amount in future bear markets. The dollars invested in the new strategy should be funded only to my "uncle" point. This is the maximum point where the dollar loss or drawdown from a recent high, is acceptable and no loss of sleep occurs.
SPDR S&P MIDCAP 400 ETF (MDY) ETF
Portfolio Metrics
Data Source: 1 September 1995 - 30 November 2022 (~27 years)
Source: lazyportfolioetf.com
MDY Drawdowns - The passive index that will be the strategy's benchmark
It will indeed be difficult to successfully achieve twice the return of the relevant index, with a similar risk profile.
Now that my strategy has clear goals, I will complete the design of the criteria for stock selection, portfolio construction, and trading rules.
Looking forward to a thoughtful 2023
best regards, Tim
Note #1. The S&P 400 index is comprised of 400 companies that broadly represent companies with midrange market capitalization between $3.6 billion and $13.1 billion as of June 2022)
Thoughts, agreement/disagreement? email me at tim@mortonir.com
Tim Morton, CFA is a retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com and a contributor to Barron's. My comments are not to be taken as investment recommendations. They are purely for discussion purposes. Please see your registered advisor for investment advice.